We start with looking at the following terms that are used in annual reports and balance sheets:
Net Asset Value (or net worth) is total assets less total liabilities divided by the number of ordinary shares in issue.
Normally a company will have a net asset value (or NAV) that is less than the current market price of the shares.
If this is not the case, an individual, or another company could very easily acquire all that company’s assets cheaply by simply buying up all its shares and taking it over.
Earnings Per Share (EPS) - This is the net profit of the company divided by the number of ordinary shares in issue. The reason we look at EPS is that it allows us to compare one year’s profit with another, even though the number of shares in circulation may have changed. When EPS is used in ratio form (Earnings Yield) it provides an easy way to directly compare two companies with different share price, assets and share base.
The Earnings statistics can tell a potential (or current) investor many things. For example, it can show that the company is using a large portion of its profit to expand operations. Such a company may be very attractive to those who for tax purposes want their investments to achieve a high capital gain rather than emphasize the dividend payout (If a company uses its profit to increase its asset base, the potential worth of each share will increase and the share price should escalate).
It is however important to note that it is possible to be creative (and legal) in a companies accounting system. A company can show an increased (or decreased) profit for a given year by simply putting sales through during one year while writing the purchased stock for it off during a different year. Of course the converse also applies sometimes with companies planning to bring exceptional profits to book later than they strictly ought to in order to avoid an anticipated profit decline.
Dividend Cover - most companies on the JSE have a dividend policy. If a company is quoted as having a dividend cover of 3, it means that the company’s policy is to pay out one-third of earnings as dividends (ie. earnings exceed dividends by three).
The retained earnings do not prejudice the shareholder (even though all the profits made were not paid to him). These retained earnings become part of the capital of a company and are listed under the “distributable reserves” in the balance sheet. This means they still form part of the shareholders’ funds of a company and will be used to increase the companies assets (buy machines, furniture, buildings, etc.). These additional machines, furniture and buildings will result in an increase in production at some future date which means an increase in earnings and higher dividends for shareholders. Also the increased asset base will mean that the share price will also increase.
Often the dividend yield from popular companies is excessively low (compared to the rates paid by banks/building societies). However, the shareholder is prepared to accept such low dividend yields (sub 5%) as his expectation is that the company will grow fast enough to increase the dividends substantially in a few years and that the share price (and thus his capital investment) will have increased accordingly.
Conversely, where a company offers a high dividend yield (say 17% / 20% or greater) it means that investors in general rate the share poorly, and few shareholders are prepared to buy even though they will receive a handsome dividend. Unfortunately some investors have been attracted by the prospect of a high dividend only to find that in time they have lost all their invested money (eg. MasterBond, Tollgate, etc.).
Using a stock exchange handbook (or viewing such information on one or more of the many Internet sites), will assist in the selection of a sound company to invest in. A few of these references also include a quality rating, which may assist an investor with his selection of shares in which to invest in.
One method of finding the best long-term investment prospects is to search for companies who have maintained or increased their dividend over at least the last five years. Few companies will agree to pay out increased dividends if they know that in the medium to longer term their profits are shrinking.
Market Capitalization - this is a term used to describe the market’s perceived value of a company. It is the current share price multiplied by the shares in circulation. This value is usually greater than the company’s net asset value.
Gearing or Leverage
This is a measure of the amount of funds a company has borrowed relative to the shareholders funds. It is generally good practice that the company does not borrow more than the shareholders funds.
If the shareholders funds of a company are 100 (million) and they borrow 50 (million), then the rate is 50%.
For this simple example lets assume that the company has 100% gearing, and so for every one rand of shareholders’ money, a company was making use of one rand of borrowed money. If it cost 10% to borrow the money and the company was showing a 12% return on total capital employed, then the shareholders would see a net 2% profit from the borrowed funds along with the 12% profit from their own funds resulting in a total profit of 14%.
This sounds good, so why not borrow more money as a 500% gearing for this same company, all things being equal, would net the shareholder 22% profit (12% plus 2% times 5)? Simply, that if the cost of borrowing is greater than the return on capital employed, you are now worse off and could start running at a net loss, even though you are making a profit (ie. The interest on the money you borrowed is greater than your profit).
Thus a company that is enjoying a very healthy return on capital employed at a time when one can borrow money relatively cheaply, may experience problems later. As more and more people notice the profits to be made in that sector they enter as competitors. To do so they borrow money and reducing the pool of available loan capital resulting in interest rates rising. Now with increased competition, prices fall and profit margins reduce. With reduced profit margins and the higher cost of borrowing, the company with a high gearing may suddenly be in big trouble.
Borrowing 30% or 40% is usually regarded as ideal in a safe company. This level would net a comfortable yield when interest rates are less than the company’s return on capital employed and it would be left with a wide margin for safety should it need to raise further capital.
A ratio of 50% is traditionally considered to be the upper limit and regarded as a sign that the company is beginning to over-extend itself.
Below 20% would suggest that management is very conservative.
Before investing, establish the gearing of the company. A company that achieves healthy profits when interest rates are low might find itself in quite a different situation when interest rates rise.
Profitability
To determine the real profitability of a company one must look closely at the return on capital employed (how efficient is the company using the resources available to it). Thus, if it makes less profit with its borrowed money than it has to pay interest on the loan, the company is far from efficient.
In real life companies have to operate in the varying conditions and during some years they might achieve very poor returns, whilst realising tremendous profits in others. A good investor will take advantage of the good years and time his exit before the bad years return.
Understanding Financial Statements
If you want to become a land surveyor, you must know how to measure. If you want to invest, you must likewise know how to measure a share or company. As you want to invest in a share to make a profit, you must be familiar with the tools used to judge its performance.
Income Statement
The Companies Act requires all public companies to publish an income statement.
The purpose of the income statement is to show the level of profit achieved during the year. It indicates turnover and tax paid and will provide information on earnings, earnings per share, dividends, dividend cover etc. As such it is the primary source of information for ratio analysis.
The Profit and Loss Account is of more use to the management than the shareholders. It will show all the minor receipts and expenses during the reported year that are not shown in the income statement.
It will also itemise the various sources of revenue and what this revenue was spent on, the surplus or shortfall being the profit or loss for the year.
The turnover, which is the gross amount of revenue received during the year before any deductions, and the operating profit, which is the profit that is left when all business expenses have been deducted, are shown at the top of the income statement. The operating profit does not include deductions for taxation, dividends or income attributable to outside shareholders.
Ratio analysis
Ratio analysis lets you compare a share with itself (one year to the next) or with another share. To do so you use information extracted from the annual financial statements (most Newspapers with a stock market page publish this information on a daily/weekly basis). Using Ratio Analysis, you can determine if a company has too much debt in relation to its shareholders’ funds, if it has too much working capital tied up in debtors or stock, how efficient it is, etc.
Take the following example:
| |
PE |
EY |
DY |
Price |
Company 1
|
5 |
20% |
10% |
1000 cents |
Company 2
|
20 |
5% |
2% |
1000 cents |
Both shares are priced at 1000 cents. Company 1’s earnings last year are one-fifth or 20% of the current share price (ie 200 cents). Out of these earnings a dividend equivalent to 10% of the current share price was paid out (ie 100 cents). Dividend cover (the number of times that earnings exceed dividends) is 2.
Company 2’s earnings last year were one-twentieth (according to the PE) or 5% (earnings yield) of the current share price. Its dividend cover is 2.5
Ratio Analysis tells us that Company 2 was less profitable than 1, but that shareholders are prepared to pay the same for 2 as for 1. Company 2 paid out a dividend equivalent to 2% of the current share price (ie 20 cents compared with 1’s dividend of 100 cents).
2’s dividend cover is 2,5 times (earnings are 2,5 times greater than dividends) which means that 2’s management is retaining a larger proportion of earnings for the future development of the company. 2’s shareholders receive only a 2% return on their capital compared with 1’s 10%.
It is clear therefore that investors rate 2 higher than 1. They are prepared to buy shares which offer only a 2% return a year on their capital, in preference to shares which would give a 10% return. The fact that 2 has a higher dividend cover than 1 means that it is ploughing back relatively more of its profits into the future development and expansion than company 1. However, 2’s 2% dividend yield is low, as is the 5% earnings yield and it would seem that the share at 1000 cents is highly priced.
Further investigation is suggested to determine which share to buy. You would probably need to address the following:
| 1 |
What are management plans for the company? |
| 2 |
What do the companies do? |
| 3 |
What are the economic conditions? |
| 4 |
What are the prospects for the companies products or services? |
With this further information, should all factors be equal, you may well consider Company 2 the potentially better investment choice.
The structure of the Exchange
A Stock Exchange may have a few hundred or multiple thousands of listed shares. These shares are not all equal, and therefore your analysis of them should not all be done in the same way. We will begin by looking at the main structure of the average exchange and its broad sub-divisions. These are in turn broken down further into the individual sectors of the market.
A general structure used by many exchanges is the following sections: Basic Materials, Consumer Cyclic Products & Services, Financial Services, Real Estate, Consumer Defensive Stocks, Healthcare, Utilities, Communication Services, Energy, Industrials, Technology.
The breakdown may differ from exchange to exchange as can be seen from the JSE’s structure, namely: Technology, Telecommunications, Healthcare, Financials, Real Estate, Consumer Discretionary, Consumer Staples, Industrials, Basic Materials, Energy, Utilities.
However, although there are slight differences in groupings and how they are described (Telecommunications can be considered Communication Services), they are not too dissimilar.
It is of great benefit to investors to have the market structured in this way because listed companies are grouped according to the nature of business that they are involved in. As an investor there will be certain sectors of the market that you are more familiar with than others and in which you would prefer to invest your money. Once you have identified these it will be easier for you to then choose the shares within that sector that you believe show the best potential for growth. Hence the way that these shares have been grouped into sectors will have made it easier for you to find different options to consider.
As an investor it is also essential to be alert to how the different sectors in the market are performing, rather than only watching the sectors that you have become familiar with. The reason for this is that not all of the sectors and shares that they represent perform the same all of the time. By keeping an eye on the performance of the different sectors relative to each other you may be alerted to good investment opportunities.
Consider the difference in performance of these two Australian sectors over the same period of time.
(click image to enlargen)
The Industrial sector has shown fairly consistent and sustained growth from 2009 to 2023. There was a correction or strong pull-back in early 2020, but as the graph shows, it then went up some 40% over the next three years to almost the level that was reached at the end of 2019.
The benefit of having invested in this sector over that time period was particularly good as a long term investment since this sector returned 200% profit in 10 years.
(click image to enlargen)
However, looking at the Australian Telecommunication sector you will see a completely different picture. When compared to the Industrial sector shown above it hasn’t performed nearly as well over the same period of time. Had you been investing money in 2009 when the Industrial sector rose and held on also for the next 10 years, at best you would have made about 5% - probably less! This was because you would have seen a 30% loss over the first two years. Then a 150% rise over the next 5 years followed by a complete loss of all these gains over the next 3 years.
If though you were investing money in this sector towards the end of 2010 and that has taken your money out in early 2015 you would have enjoyed the 150% gain. Coming back in during early 2020 and leaving again in under 2 years would have netted you a further 60% profit. (NB We are referring here to the sector as a whole. Individual shares within the sector may have performed very differently.)
(click image to enlargen)
The Health Care sector has in turn performed very differently from the two sectors mentioned prior to this. There would have been occasions during the same period that it would’ve been more profitable for you to have owned shares in this sector.
This brief exercise has demonstrated for you the importance of looking at the entire market rather that simply investing in a particular sector that you have become familiar with. Depending on your style of investing and the period that you intend to invest(short, medium or long term) you need to ensure that you are in the sector that will prove to be most profitable for you.
Mining Share Analysis
The Mining sector (usually falls under the Basic Materials broad category) is usually the most volatile sector of the Exchange. Fortunes have been made and lost more quickly in this sector than in any other. That is why anyone who invests in them needs to be cautious. Should you decide to invest, do so only when you understand the fundamental differences between them, and that of shares in other sectors.
Shares in other sectors of the market usually experience a fairly constant supply/demand for their products. For example a company in the Retail Stores or Food sectors knows that come what may, people still need to buy food and clothes. Thus their customer base remains constant, varying slightly, dependant on the economy.
Presuming that the companies are well-managed, the investor who buys shares in these sectors is assured of constant dividends. The companies profitability will not fluctuate wildly from month to month (or in any unpredictable way). The share price itself will thus track the sector which in turn varies with the economic cycle of the share market itself.
Mineral producers, on the other hand, have to contend with frequent changes in the exchange rate of both the local currency and that of the markets they supply. They also have to cope with the disparity between this country’s inflation rate and that of most of their trading partners. In addition to this they have no say in the price at which they can sell their produce (eg. Gold) as this is fixed by others. The price of their product can also fluctuate unpredictably over a very short period.
Competing in the open world market is tough and a few cents a ton can often make the difference between a profit or a loss. The situation becomes more risky when the customer wants a long-term supply contract and the competing suppliers operate in countries which have a lower inflation rates than ours. A mine which enters into such a contract and gets its long-term estimate of inflation wrong can quickly find itself in a loss-making situation as it’s rising internal costs soar above the break-even level.
Couple this to a large consumer country (eg. United States, etc.) going into recession and suddenly the demand for a product can radically, diminish resulting in plummeting prices, despite the constantly rising costs the producer has to contend with.
In addition, as technology advances, it dramatically affects the demand for various metals and minerals (A change in the way car emissions control is implemented - catalytic converters - can affect the world demand for platinum). Just because there was a great demand for a product yesterday, it may not prove to be so today, or tomorrow!
Clearly then, mining (and the owning of its shares) is a risky business! However, the world has a large and increasing need for minerals and so it is not surprising that well-managed mining companies can be huge profit-makers when things go well. That is why they are such an important market sector and why investors must understand their workings.
You cannot analyse a mining share in the same way as a financial or industrial share. A striking difference is that no mining company has been able to achieve a long history of consistently rising dividends and earnings.
(click image to enlargen)
 The chart here shows the JSE Basic Materials sector over a 40 year period. A decade of sideways movement, followed by 8 years a great growth and then 15 years of sideways movement again! Recently a 6 years growths spurt, but the last two years again show the start of lackluster performance.
Just as other shares are affected by interest rates, mining shares are influenced by the exchange rate. As lower interest rates are beneficial to non-mining shares, a weakening rand benefits most mining companies as it makes it easier for them to sell their minerals abroad.
Provided one buys mining shares at the right time and understands that these shares can seldom be bought as long-term holdings, one can be confident of making good capital profits and of earning reasonable dividends from them.
Evaluating Gold and other Mining Shares
As mining shares, they can only be compared with other mining shares, or preferably, other gold shares. Gold shares represent, in market capitalisation terms, the most important sector of the JSE. As this industry is responsible for a large portion of our foreign exchange earnings, they are by far South Africa’s financially most important sector.
Mines tend to produce an overwhelming array of statistical information, in addition to the standard yearly company report. Every three months gold mines report their operating results and the market responds accordingly. Overseas investors who hold large blocks of South African gold mining shares frequently react more decisively to South African political events (strikes and rumours of unrest), by dumping their share holdings. Varying exchange rates also impact on the price overseas investors will pay. Both of these factors substantially impact on local share prices.
From the large array of statistical information produced, there are three basic mining figures the Gold/Mining investor needs to concentrate on. These are:
The Gold (or whatever the mine produces) Yield
This is the amount of saleable ore produced from every ton of material mined and is usually expressed in grams per ton milled.
The richness of the underground ore seams frequently vary considerably. Some mines can influence their average yield to a great extend to suit their long-term objectives by concentrating on richer or lower yield veins. When the international price of gold is high, they can extract lower grade ore without reducing total profits and thus prolong the life of the mine. If the price falls, they concentrate on the richer seams.
Unfortunately, older mines and those with generally low-grade ore deposits do not have this much flexibility and their profits - or losses - tend to mirror, the fluctuating international price of gold (in rand terms).
When investing in a gold mine, note its ore flexibility, as the greater this is, the safer that mine is.
Production Costs
Individual mines cannot pass on rising costs to their customers as the international price of gold is fixed and is the same for every mine (world-wide!). When costs rise, the profit margin of a mine can be seriously eroded.
It is thus vital that an investor who intends buying gold shares should have a good understanding of the cost trends of the desired mine.
At the end of January, April, July and October (ie. Every quarter), all the leading mining companies produce detailed statistical reports. They also provide comparative figures for the previous quarter and for the financial year to date. Operating costs are expressed in terms of rands per ton milled. These are the total operating costs for the past quarter divided by the total tonnage of ore that is crushed and processed in the mine’s recovery plant.
Tonnage milled
This is not the material mined (which can often include non gold bearing material removed to reach the seam), but rather the material processed on the surface. Often this tonnage milled was mined during some previous period (usually large stockpiles of ore are kept on the surface awaiting processing, to ensure production when shafts are shut down for maintenance, or during a strike, etc.).
When analysing your mine, watch for:
| 1 |
Rising costs |
| 2 |
Falling grades |
| 3 |
Declining reserves (comparisons with previous quarters/years are given in the quarterly reports) |
| 4 |
The size of the capital expenditure |
Mine Categorisation
Normally mines are grouped into four categories, namely:
| Rich/Long-life |
These are high grade mines |
| Medium grade |
Your average mine |
| Short life |
These mines with low reserves left |
| Marginal |
These low ore producing (low yield) |
The dividend yields of the mines also vary considerably depending on their risk and future potential.
Mines are “wasting assets” as once all the ore has been mined, there is little the company can do but sell off the remaining assets, including the freehold land, to realise some of its break-up value. This is different to a manufacturing company where, provided the raw materials can be supplied and the demand for the product is strong, the company can continue to produce indefinitely.
Mines therefore have limited life spans.
In view of this, shareholders should expect to receive higher dividends than could be received from a normal manufacturing or non-mining company.
A shareholder should build into his expected return on investment an allowance for the wasting assets he has invested in. This is known as “amortisation”.
This means that the shareholder will expect to recover part of the capital invested from the dividend distribution. So mining shares will usually have higher dividend yields than non-mining shares, particularly where the mine has a short life span.
Forward Selling
A number of mines will sell their future production of ore forward on “futures markets”.
They take out a contract to supply a certain amount of material at a future date, at a price agreed upon today.
No matter what happens to the price, the mine is guaranteed a fixed price for its production.
This works in the mines favour if the mineral price is expected to (and actually does) fall. For example, let us assume that gold is trading today at $450 an ounce - a gold mine undertakes to supply 1 million ounces at $450 an ounce 12 months from today. One year down the road the gold price is $400 - the gold mine still sells its gold at the agreed price. If, however, the gold price went the other way, to $550 an ounce, the mine loses out.
Many mines sell a portion of their future production on the futures markets, and the balance on the “spot” market (currently available production sold now at the current price). A mine which does not forward sell a portion of its gold production is said to be speculating on the gold price. In times of uncertainty, gold mines will sell forward a larger portion of their expected gold production.
Industrial Share Analysis
The first thing to remember about Industrial shares is that Industrial operations are frequently capital intensive, requiring expensive machinery and factories in order to produce something. The margins (ie. profit in relation to total assets is low) with Industrial operations tend to be lower than in other businesses.
As with all shares, start by looking at the annual financial statements of the company. You can establish a trend on the companies profitability over the last few years, the size of debt in relation to equity, working capital, total assets, etc.
Another source of information can be your Stockbroker. Usually stockbroking firms have research teams that spend considerable time investigating the operations of various listed firms. Often they have met the management team, researched the companies operation, analysed its financial reports, etc. and as such, should have a reasonable idea of the future prospects for the company. In addition, some research departments will use technical analysis to provide further information. Your stockbroker may send out daily (if you are a very, very good customer), weekly or monthly (the average customer) reports that you can consult. Depending on your relationship with your stockbroker, you may be able to phone him and discuss prospective investments with him and get his thoughts.
Industrial Indices
The Industrial Indices (like all indices) are a very good way of determining how a particular sector of the market, or even the market as a whole is performing. If you have not decided which sector to invest in, looking at just the various Industrial Indices will quickly give you a good idea of which areas are or may soon do well. Once you have established which sector you wish to invest in, next identify the best potential performers in that sector as you would like to be invested in the shares which go up the most.
The Industrial Index (JSE-INDU, X2-INDUST, FT-INDM, etc.) as the overall index of all industrial shares will show you what the economy as a whole is doing.
The performance of certain sectors will give you an idea of what the economy may soon do. It is generally recognised that when the paper and packaging index starts to pick up, this precedes a general upturn in economic activity. The reason for this is that at the start of an economic boom, businesses anticipate higher sales and they start to produce more and stock up - this requires more paper packaging and cartons. So the Packaging and Printing Index is an early warning sign of a turnaround in the economy.
You will note that certain sectors start to perform at certain stages of the economy. Just as the Packaging and Printing upturn precedes the economic turnaround, next the Retail Stores sector will start to perform. As we continue in the cycle consumers will demand more credit from banks, so the Banking sector’s margins will usually improve. The Government will further attempt to stimulate this economic growth by reducing interest rates and making it cheap for people to borrow.
Once the Industrial Consumer sector has started to respond to the improved economic conditions, the Beverages, Hotels & Leisure sector will next respond (more disposable income around for people to spend on entertainment and holidays). Later in the cycle you will find the Building, Construction & Engineering sectors improving.
Other related sectors such as Property will be slower to take off as such investments take a long time to generate a return (First raise the capital to build, carry out the construction work, let the property and then receive a return). They will also be amongst the first to take strain as the economy starts to go into recession!
Thus watching the moves of these various sectors can yield much information to the astute.
Conclusion
The performance of industrial companies on the JSE is closely linked to the performance of the economy at large.
Although you can analyse the various sector indices knowing that the shares in that sector will in general follow their index, remember that each company is unique and thus needs to be looked at individually.
In general, consider the following:
| • |
Although there are many factors that can determine the level of earnings for a company, most are closely related to economic events and trends, so study these first! |
| • |
If a company relies on Government contracts, ascertain to what extent. Similarly if that industry is dictated by Government regulations (ie. Motor Industry - percentage of imported components, etc.) |
| • |
If the company either imports or exports, look at what the future prospects are for the local or applicable international exchange rate(s) |
| • |
Analyse the gearing employed in relation to expected inflation moves as this will affect profit margins |
| • |
Examine the companies market share and profit margins and determine how current and future competitor’s may affect these |
Splits & Consolidations
From time to time a company whose shares are trading at a ‘high’ price may announce a share split - say ten for one (ie. You get 10 new shares for every old share you hold). A Consolidation is the opposite where one new share is given for every 10 old shares. With a share split every shareholder suddenly owns ten times as many shares as previously, but each is initially worth only one-tenth of its previous value. (With the Consolidation you finish up with one tenth the number of shares, but each new share is now valued at ten times the value of each old share). The ratio of the split / consolidation will vary from company to company.
Initially it seems pointless as the shareholder has neither gained, nor lost varying the size of the slice does doesn’t affect the overall size of the cake!) However, there are good reasons for doing it. If a share is very expensive, small investors may not be able to afford to buy the minimum 100 shares (ie. A single 100 share deal of Apple shares costs in excess of $17 000.00, Warren Buffet’s Berkshire Hathaway stock costs in excess of half a million USD per share!). Thus a split can make the shares more affordable and increase the spread of the share ownership base.
Some however feel that share splits benefit large well informed shareholders who then dump their holdings onto small investors who can now “afford” the share.
Studies undertaken in the USA seem to indicate that splits frequently occur near but not quite at the top. Following the split, the shares rise a little further; then follows a sideways movement when supply and demand battle one another, and finally the share declines to well below the price at which the split occurred.
In South Africa a study over the last 10 years has shown that although some shares have exhibited this pattern, in general, quality shares have continued to rise despite being split!
Rights Issues
The term ‘rights issue’ refers to the process through which a company raises more equity capital by creating new shares which are offered to existing shareholders at a price lower than the prevailing market price. This will tend to make the issue attractive, and induce many shareholders to ‘follow their rights’, that is, buy the new shares.
For those who do not wish to do so, however, a document known as a renounceable nil paid letter is provided, which enables the holder to sell the right to buy the new shares at the issue price.
These renounceable nil paid letters - NPLs, as they are commonly referred to - may be traded on the JSE in the usual way. In theory, their price ought to be the difference between the current price of the share and that at which the new share will be issued.
In practice, however, considerable variation may occur, depending on how media commentary and sentiment affect the interaction of supply and demand.
If the investor is confident that the share in question has good long term potential, this can be a good, less expensive way (than buying them from some other shareholder at the later date) of increasing his share holdings in the company.
Capitalisation Issues
The mechanics behind a Capitalisation issue is very similar to a share split as the number of shares in issue increase and the value of each share decreases accordingly.
The difference in essence is the reason for doing the capitalisation issue. If a company has been listed for many years (decades) it is possible that on the balance sheet the value of retained earnings (funds kept back for future expansion, etc.) rivals the size of the original issued share capital (which would have remained fixed at its original value). The ratio of assets to issued share capital will thus suffer.
Thus a Capitalisation (or Script) Issue will be made and each shareholder will be entitled to a number of extra shares for every existing share held. Part of the retained assets will be transferred to the share capital to finance the extra shares.
For example, a company had an original share capital base of 10 million (issued 100 million shares of 10 cents), and now has retained earnings of 60 million. It now uses 30 million to acquire assets, namely issued capital in itself. The share capital base goes from 10 to 40 million (10 + 30) and the shares in issue go from 100 to 150 million. Thus every shareholder gets an extra 50 shares for every 100 he has. The value of his total holding remains the same and thus the value of each share decreases accordingly.
Cautionary Announcements
Cautionary Announcements can be made for various reasons. The purpose of such announcements is simply to inform the investing public that the company in question is in negotiations with other parties that may result in a future business deal. It could be that the company is looking to buy out another company, merge with another company or be bought out itself. It could also be issued if there were discussions within the company on perhaps top management changes or future company direction. As can be imagined, such situations could affect the value of the company and hence its share price.
Cautionary Announcements are thus issued so that investors are informed. It helps to combat insider trading (discussed next) as now everyone, and not just a privilege few are informed.
Sometimes the company may, in consultation with the Exchange, suspend the trading of their shares during negotiations or until an official announcement is made.
Cautionary Announcements do not suggest what is happening, just that something that may affect the share price is going on. At such times investors would be unwise to invest suddenly or sell as the announcement does not indicate whether the negotiations will be good, bad or indifferent. If you are invested in a company that issues a Cautionary Announcement, consult your financial adviser (stock broker) for assistance or simply hold tight for the official announcement.
Insider Trading
Obviously there are those people inside or related to a company (ie. senior staff, directors, company accountants, major share holders, etc.) who are privy to information relating to the companies current or future operation long before such information becomes common knowledge.
They may know that some good news is about to be announced by the management (such as a big jump in profits or the buy out of another company) which will dramatically improve the company’s profitability. Conversely they know of some major problem that will soon cause investor confidence to wain.
These ‘insiders’ then quietly contact their broker and start buying more shares (or selling their current shares). They do this ahead of the news being announced knowing that when it is, the share price will respond accordingly. The share deals could even be done in a relative’s name or by a company (in which they are a major shareholder), etc.
The use of such secret or insider information for personal gain constitutes insider trading. The term ‘insiders’ was coined in the USA and this form of trading is illegal worldwide. As can be imagined, it is virtually impossible to police.
To illustrate this you need only wait for an exceptionally good set of company results to be announced and then go and look at a graph of the volume traded in that share. You will see that heavy volumes were traded just before the results were announced indicating that people with inside knowledge of those results were buying the shares.
How to Buy Shares/Stocks
All shares have to be bought through a registered stockbroker. Some brokers require a substantial deposit from an individual before they are prepared to do business but there are brokers who are prepared to look after the private client with no initial deposit. Your criterion for choosing which broker you would like to act for you will probably be on the recommendation of a friend. Most brokers will offer free investment advice and newsletters but share forecasting is an imprecise business and all brokers have their fair share of mistakes as indeed they have their fair share of successes.
Most business is done over the Internet today. The broker will place the order at the agreed price limit or “best”. As soon as the broker knows that your order has been executed, he will report back to you, by telephone in the old days (and perhaps still today if you are a high-net-worth client), but usually electronically, to confirm the purchase or sale. The morning following the execution of the order, an invoice known as a “broker’s note” will be issued directly to you, confirming the deal.
This broker’s note records the details of the purchase or sale of securities, including all charges and taxes payable. Purchases must be paid for within seven business days from the date of the transaction. If you have not paid within seven days you will be “sold out” and will be liable for any difference. On the sale of shares, the shares sold together with a properly signed transfer form must be delivered to the broker’s office within seven business days, otherwise the broker will be forced to “buy in” the shares on the stock market and bill you for any shortfall.
You will receive a monthly statement which reflects your script and financial position. The statement reflects all your transactions during the month, e.g. purchases, sales, cash transactions, etc. Today it is usual for your broker to provide this information, via their website, for you at all times with the latest values.
Banks and institutions are usually able to deal direct with the Eexchange and not go through a broker. No longer is there a set brokerage and this will be negotiable with the broker dependent on the volume of trade done through the broker.
Because the institutions control such large amounts of cash, they have ended up controlling the vast majority of shares listed on most exchanges. This is because people who need life insurance cover or assurance pay in large amounts of money in the form of premiums each month, these life companies generally have huge resources at their disposal. They invest this money partly in the stock exchange. Over the years they have built up huge share holdings in a number of different companies, giving them a strong grip on the market.
The unit trusts or mutual funds are also big players in the market. These Companies invite members of the public to hand over a certain amount of money to invest on their behalf. This money is then pooled with monies from hundreds of other private investors who do not want the bother of investing their money themselves, and shares are bought on the stock exchange. As the value of these shares move up and down, and as dividends are continually being paid on those shares, the value of the units move up and down.
A private investor will always be able to react faster than a unit trust manager. Because the private investor only holds a few hundred or a few thousand of any one share, and any one company normally issues millions of shares, he can quickly dispose of these shares at a better price.
An institution or a unit trust may hold millions in any one share - they cannot sell them quickly because there are not enough buyers in the market. Furthermore, if it was known that millions of shares were for sale on the market, the price would drop like a stone - the law of supply and demand comes into play every time.
Market Cycle
There is obviously always a right and a wrong time to buy shares. To identify the right time to invest or take profits, requires a basic understanding of the economic cycle of the country you are investing within, which is simplified below:
| 1 |
During times when money is in short supply interest rates will rise.
This will cause dividend yields to fall.
This is not the time to enter the market.
Rather you want to time your entry into the market as money supply improves and interest rates start to level out and fall.
When interest rates fall, share prices will rise. |
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| 2 |
The South Africa’s economy for example is influenced by the price of Gold and its agricultural crop.
A large portion its export earnings comes from Gold.
In times of good rains and bumper crops, they are able to export food surplus at big profits.
Consequently, the balance of payments situation moves strongly into credit and farmers have a lot of money to spend.
This has a beneficial spin-off to other sectors of the market and industrial shares start taking off as well.
Industrialists seek to cash in on a booming market by expanding their factories.
They borrow money to build factories and to import machinery, and because our balance of payments position looks good, overseas lenders deduce that the rand is strong and are happy to lend money.
The economy improves, and share prices rise. |
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| 3 |
However, as this cycle develops further, we begin to run out of skilled labour.
Firms compete for experienced staff by offering increased wages.
This means that many people have more available funds for purchasing luxury goods.
The demand for luxury goods will outpace local production and result in higher imports.
With this increase in importing, the balance of payments position will move into a deficit.
The Rand starts looking weak and overseas investors become wary of lending money to South Africans.
As money is now in short supply, interest rates rise and the share prices tumble in sympathy. |
Consequently, to obtain maximum capital growth one should be buying in the latter part of stage 1 and selling during stage 3.
If you continue to hold all your shares while this cycle repeats itself, you will only improve your portfolio by the amount by which the companies in which you invested, grow wealthier.
Interest rates are usually set by the Reserve Bank (The Prime Rate) and by following their progress can help you identify the above mentioned cycles.
When identifying the current phase of the market that we are in, remember that the share price often reflects peoples sentiment regarding the company’s future performance. Hence, even if you correctly identify that we are in a down phase, it may still be the correct time to buy if people believe that company will improve.
Product Cycle
In addition to the general market cycle mentioned previously, that affects all the shares on the exchange overall, a product cycle is applicable to shares in certain sectors of the market.
Retailers for example experience their greatest volume of sales during the last three months of the year. Note how in the LSE’s General Retail Stores sector (FT-GENR chart on right), the shares on average have always risen considerably during the latter months of each year.
Similarly, those companies involved in the beverage sector will experience greater sales in summer than in winter and so on.
Very often the seasonally varying demand for a product will be reflected in the share price of the companies suppling/producing that product.
Investor Behaviour
Just as when a few cattle move in a certain direction, the rest of the herd, not wanting to be left behind, follow (regardless of the direction!), so do investors in the market. When a share price is moving steadily upwards, investors see an opportunity to make a profit and so they buy the share. Accordingly, the market goes in three identifiable stages:
| 1 |
As more people are buying shares, fewer shares are available - demand exceeds supply, which may force the price higher.
There are always a limited number of shares available to buy, but in theory demand is unlimited (within a given price range).
People will always pay more for the shares they want to acquire.
The more demand grows, the faster supply drops, and up shoots the price. |
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| 2 |
However, sooner or later the share price reaches a point where people are no longer prepared to pay the price, and will look elsewhere for good shares to buy.
Once the demand is gone, the price will fall.
Investors do not want to hold a share that is falling in price, so they will be tempted to sell and cash in their profits.
If everybody thinks like this, then the share price will drop rapidly.
Hundreds of investors may be trying to sell their shares while very few are trying to buy. |
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| 3 |
The price will drop to the point where a few smart investors perceive it to be good value.
They start buying the share when they think it has reached a bottom and very soon the price starts rising again. |
Then those who do not want to be left behind start buying shares and we are again into stage 1 as the price accelerates upwards.
J Paul Getty, the oil tycoon, was famous for saying “Buy when everyone else is selling, and hold until everyone else is buying”. This is not just a catchy slogan, it’s the very essence of successful investment.Based on the above, it is possible to divide investors into three main groups:
Those who are very weary of taking risks and continually want to know what “everyone else” thinks and keep asking the same questions over and over again. By the time they eventually decide to invest in a share, the market will have discounted the news as share prices tend to move in anticipation of future events. The result is that they tend to miss the profitable part of the share movement, buying at or near the top, and selling at or near the bottom.
The other group have far less fear of taking a risk and are able to take action, even if nobody else follows them. They are often able to identify value in the share market, and will not hesitate to buy a share that has declined substantially. Although they are in the minority, they control greater financial resources than the former group.
The above two groups are the extremes and most investors fall into a group somewhere in-between.
A Few Good Tips
Take the time to learn from experienced investors who have proved to be successful in their market investments. There are many good lessons to be learnt from them.
Warren Buffet, generally considered to be the worlds most successful investor, believes that the market seldom reflects true value. He feels that markets tend to overreact on both ends of the scale as shares are either overpriced or underpriced. He therefore takes time to determine for himself the intrinsic value of the company. The way that he does this is by identifying a company that has a strong balance sheet, produces an increasing amount of cash, has a unique product advantage and strong management.
Once he has identified such a company and he has purchased shares in that company, he aims to keep those shares for at least five years. He doesn’t allow himself to be swayed by the markets’ view of those companies but if they fit his own criteria he holds onto them. Like any investor, he is careful about the price that he pays for shares in these companies. If a company is not selling at the right price, he will wait until it does. In some cases he may have to wait for years but he is a patient investor and it is usually worth the wait.
What we learn from investors like Buffet is that we all need to determine our own investment philosophy and then stick to it. Understand that with shares you are buying part-ownership of the company so one must have a good feel for the type of business that the company is in. Then, using common sense, you will need to work out wether it’s the kind of field that has prospects or not. You will have to put in some effort and probably learn some painful lessons along the way but with your own well thought out philosophy and an investment advisor/fund manager to assist you in making things happen you have the potential to make a success of your investments.
Another important point to bear in mind is that you must never borrow money to invest in shares. The market has on average out performed every other investment vehicle and so one may feel that it is worth investing borrowed funds. However, remember that the returns on the market are good when calculated on average but there have also been many investors that have lost everything that they have invested in certain shares. So you don’t want to risk money that you can’t afford to lose. Rather put that cash into your home loan.
Most of what has been covered in this section up to now can be summarised well in the following points put together by Charlie Miunger:
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Always invest from a business perspective |
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The company must have a sound established earnings track record and preferably a consumer monopoly |
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The company’s future earnings must be reasonably predictable |
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Concentrate on things that are knowable and run with the winners - Your best next purchase could be the stock that you already own |
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Once you have established what to buy, be patient and wait for the right price |
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Don’t become emotionally involved in the market - Think correctly and independently |
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Time adds value - the magic of compounding |
By now you should have grasped how to analyse mining and industrial shares based on fundamental analysis. You should also be able to examine the financial data of these shares to decide which shares you would like to invest in.
You are now familiar with the implications of share splits, capitalisation and rights issues, cautionary announcements and so forth, and how they may affect the value of the shares you may own or wish to own.
Having in the last part of this lecture noted how the market moves in cycles, you are now at the point where you can both select shares and identify the approximate time to invest. What you now need is the ability to pinpoint the exact time to buy and sell. This you will only be able to do by using Technical Analysis. The general basics of this exhaustive subject will be discussed in the next two Lectures. The last lecture of this course will discuss some more advanced areas of Technical Analysis.
First, though, starting with Lesson 3, we look at the types of charts you can use and then move to the all important subject of patterns and how you can identify them to your advantage.
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