Investment principles and risk

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Our audiovisual presentation provides an introduction to the methods of analysing share valu...

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...classes.

This chapter specifically looks at equities, property and alternative investments.

An equity or ordinary share represents a part-ownership of a company’s capital. Investors will buy shares expecting to benefit from income in the form of dividends and to receive capital growth on their investment. The expectation is that as the company grows dividends and capital values will also increase. Shortened demo course. See details at foot of page.

...ng stock exchange facilities.

Even though small limited companies still offer the same basic features as their larger, listed relations, they are fairly illiquid in that there will be fewer buyers and sellers wishing to make a trade.

By what name is an equity also known?

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Both the expectations of the markets as a whole and investor sentiment will have a great deal of impact on supply and demand and subsequently on equity values. 

The connection between the attitudes of the markets on various company shares derives from factors such as the political and economic environment and expectations of a company’s profit-making capability. Past performance of the organisation can act as a strong guide but will not definitely predict the future.

A large part of the company’s ability to thrive, taking into account these factors will depend upon the quality of the management team in charge of the organisation.

External economic and political factors

Changes in the pattern of economic activity such as inflation, product...

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...y of the people who are running the company and ultimately responsible for its success or failure. Looking at previous experience could help to highlight how well the team or individuals have coped with difficult decisions in the past and how the company has been managed in the past but this is, of course, not a guarantee that the same trends will be followed in the future. A management team that has made good decisions in the past and has proved to be successful can have a positive impact on the share price. However, where an influential individual leaves a successful management team this can raise questions and can adversely affect the share price of the company.

How can positive investor sentiment affect the price of an equity?

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The buying and selling of shares in the UK mainly takes place on the London Stock Exchange (LSE), which serves as both:

The Primary Market – where securities are sold for the first time to investors to raise money for the company; and

The Secondary Market – where securities that have already been issued can be bought and sold between investors

Trading in the secondary market does not directly impact on the finances of the company that initially issued the shares, howeve...

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... than for listing on the main market. The objective is to provide accessibility for young and developing companies seeking to sell shares in an orderly and regulated market.

The shares of AIM companies can be described as 'quoted' or 'traded', but as they do not fall within the definition of a company with a full listing on a recognised stock exchange, they should not be described as 'listed'.

What is the Primary Market used for?

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Investors can buy and sell equities through stockbrokers, or through a bank or building society that has links with or owns a stockbroker. The main costs associated with buying and selling equities are:

Bid-offer spread

Commission

Stamp Duty/Stamp Duty Reserve Tax (SDRT)

Panel on Takeovers and Mergers (PTM) levy

Bid-offer spread

This is the difference between the price that a broker will buy an equity (the bid price) and the price at which they will sell (the offer price). The difference between the two prices is known as ...

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...£5

SD is not charged on transactions of less than £1,000

SDRT is rounded up or down to the nearest penny

Panel on Takeovers and Mergers (PTM) Levy

PTM is the regulatory body that oversees any takeovers and mergers of companies listed on the LSE. The funding for the panel is derived in part from a flat rate of £1 charged on all deals that are valued at £10,000 or more.

Identify the two UK taxes that might be charged in respect of the purchase of UK registered equities?

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There are two main types of share capital, ordinary shares and preference shares (although there are a number of variations within these two types). They are differentiated in terms of:

The right to income (dividends)

Voting rights or the ability to control the company

The right to a return of capital on winding up

The ability to issue different classes of share can be useful where the company wishes to allocate different rights or privileges to different groups of shareholder. The individual rights of each share class could potentially differ in one or more of the following ways:

The extent of their voting rights

Whether or not they can receive dividends

Whether the dividend is guaranteed or variable

The payout received on winding up

There is no statutory limit which restricts the number of classes of shares that a company can create provided the correct procedures are followed, which include the necessary company resolutions and board minutes authorising the issue of additional classes of shares.

Ordinary Shares

Ordinary shares are by far the most common form of equity security and usually form the bulk of the share capital of a company. They are defined as any shares that are not preferred shares and do not have any predetermined dividend amounts. An ordinary share represents equity ownership in a company and entitles the owner to vote in matters put before shareholders in proportion to their percentage ownership of the company.

Ordinary shareholders' rights can be summarised as follows:

They are entitled to share equally in all dividends declared by the directors. The amount of the dividend will depend on the profits of the company, and the residual amount after the pa...

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...into ordinary shares at pre-set dates and pre-determined terms. Their prices respond to both the fixed payment and the convertible element. If the ordinary shares increase in value and it becomes likely that the conversion rights will be taken up, then the convertible share price will generally track the ordinary share price.

Risks

Shares are considered a relatively high risk investment and are subject to the following risks:

Equity capital risk – the price depends on supply and demand and can drop if the company performs badly and produce a low level of profits

Share dividend volatility – dividends can fluctuate at the discretion of the company

Currency risk – investing in companies outside the UK involves the risk that the foreign currency will fluctuate in relation to sterling

Liquidity risk – there may be a period of time before the investment can be converted to cash

Counterparty risk – there is always a chance that the company/organisation will fail.  In order to protect consumers better, the FCA has looked to firms to enhance their risk disclosure to investors

Fund managers and insurance companies – there is always the possibility of these parties failing and this cannot be totally ignored, despite the increased regulation and protection now in place

Regulatory risk – this is a greater threat in countries where the investment markets and commercial life are less stringently regulated

To attempt to limit the risks, investors in equities should be prepared to diversify their investment across different shares, in different sectors and across international markets.

What are the two main classes of share capital?

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Private equity is considered to be an asset class in its own right, and generally involves either buying or taking a stake in companies that are not listed, or publicly traded on a stock exchange.

Private equity involves providing medium to long term finance to unquoted companies in return for an equity stake. Private equity investors will generally consider unquoted companies with high growth potential to compensate for the potential risks. The term 'private equity' is typically used to refer to the provision of venture capital and management buy-outs and buy-ins.

A private equity firm is looking for a reward through the company’s success, and will generally seek to r...

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...sk of loss, as a higher percentage of unlisted companies will fail or will not grow as quickly as anticipated. Due to the nature of the investment there is little diversification and the companies would tend to have narrow or even a single product range that would be much more susceptible to economic downturns.

Where they have stock market listing, private equity securities tend to be more illiquid than other listed securities; they can be sold less readily in large amounts and transaction costs tend to be higher. The share price can be volatile as trading volumes can be very low.

In which type of companies do private equity funds invest?

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When using measures to determine the actual or prospective performance of a company, the investor will be concerned with some key measures relating to:

Income prospects e.g. dividend yields

Growth prospects e.g. using Price/Earnings (P/E) ratios

Security prospects e.g. using the company’s net asset value (NAV)

Data used may be historic or prospective.

Historic data uses past actual results

Prospective data considers projected results using factors linking probability of returns in the future

Historic data is exact but can be out of date

Prospective data is more up to date but only as good as the assumptions being used. It may include some subjective judgement from commentators

The data used will depend upon the needs of the investor

We will now look at some key measures of company performance.

Earnings per share

This allows an investor or analyst to assess trends in a company’s ability to generate profits. It is also one of the most widely quoted statistics in relation to a company’s performance, as all listed companies are required to publish EPS in their accounts.

The formula is:

Profit attributable to ordinary shareholders/Number of ordinary shares in issue

Profits in this context are those payable after tax, minority interests, extraordinary items and preference dividends.

Example

XYZ Ltd has net profit after tax and all other deductions of £500,000. There are preference share dividends to pay of £25,000 and there are currently 10,000 ordinary shares. The EPS is as follows:

£500,000 - £25,000/10,000 = 47.5p

In this example, XYZ Ltd has earned 47.5p of profit for each share

Note:

Not all companies distribute all available profits to the ordinary shareholders. Any retained profits are not lost, as the...

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...realisable, such as property companies or investment trusts. However, the share price will be affected by supply and demand

It is less useful for companies that are valued on their earnings potential, where shares would generally trade above the NAV. This is because investors are willing to pay something for the goodwill inherent in the business

The NAV is a useful valuation in the following circumstances:

If a takeover bid is made, shareholders can compare the bid price to a realistic NAV to check if the price offered is reasonable

If liquidation seems a possibility, the NAV provides shareholders with an indication of the amount they are likely to receive and helps them judge whether to hold or sell the shares

Limitations of investment ratios

Percentages and ratios can be useful in the assessment of trends and comparisons with similar companies. There are, however, a number of limitations:

Different companies will use different accounting policies to calculate profits and value assets. This could make comparing companies in the same industry difficult

The management may decide to change accounting policy making a comparison of trends over time difficult

Many ratios are calculated using historical data from the accounts, but this may not be the best guide to future performance and investment potential

When considering trends over a number of years, high inflation can produce misleading figures. The reported figures may show an increasing trend, but in real terms they could be static or even declining

Investment ratios can provide a useful guide, but they should never be taken in isolation and further research is always recommended.

Which ratio compares the relationship between the stock price and the earnings of the company?

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Stock market indices bring together the movements of company share prices and show which way the market moves over time. They give the ability to measure performance of a portfolio of shares over different periods. The index provides a number used to compare the value of companies at different points in time.

They can be used for a number of reasons:

Comparison of the performance of a particular share with its sector of the market as a whole

To evaluate market movements with the intention of predicting trends that may continue in the future

Compare the performance of a fund manager with the performance of the market as a whole. Many active fund managers aim to beat the market. Passive fund management aims to track the market

Variety of Indices

The majority of indices around the world relate to equities but there are indices that reflect most types of investment.

Portfolio managers will choose the most appropriate index from which to compare their overall portfolio of investments, i.e. the one or ones that most closely relate to the portfolio’s constituent parts.

FTSE Russell

FTSE Russell is owned by the London Stock Exchange and provides a range of indices and data services that are widely used.

They are all weighted according to capitalisation. The larger the company, the bigger the weighting in the index and therefore the more effect its performance will have on the index.

FTSE constituent weightings are adjusted to reflect the free float of shares in each company in accordance with FTSE rules, to reflect the actual availability of stock in the market for public investment.

The main UK equity indices relate to different levels of capitalisation, of which the FTSE 100 is the best known and most widely used.

FTSE All-Share Index

The FTSE All-Share is a market capitalisation weighted index representing the performance of all eligible companies listed on the LSE main market. Today the FTSE All-Share covers over 600 companies, which is approximately 98% of the UK’s total market capitalisation.

The index works as follows:

It is an aggregation ...

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...argest 40 quoted German companies

It is calculated in real time

Its value is weighted and is the basis of futures and options traded on the DTB (Deutsche Termin Böurse)

The index includes reinvested income

Hong Kong equities

The Hang Seng Index is as an indicator of  broad movements of the Hong Kong stock market

It is made up of a representative sample of Hong Kong stocks and is value weighted

French equities

The CAC 40 is a real time, value weighted index of the largest stocks

World equity indices

The FTSE operates the FTSE All-World Index, which is an aggregate of just under 4,000 stocks from 49 countries.

The MSCI World Index series is another widely used overseas index.

Limitations of indices

Indices are widely used for comparing the performance of actual portfolios, and while they are useful, it is important to understand how they are constructed and their limitations.

Most modern indices (including all the FTSE indices) are weighted by market capitalisation, which means that they reflect the relative value of big and small companies on the market. Some older indices use a cruder average of price movements.

In a fundamentally weighted index, the weight of each company is based on factors other than just price, such as the company’s revenues, earnings, number of employees and dividends.

If an index reflects changes in capital values only, it is ignoring reinvested dividends which can make a big difference to long-term performance. Most indices can also be calculated with an allowance for dividend income reinvested, because they provide a record of yields from the shares in the index. The FTSE All-Share Index and its subsections include a total return index based on net reinvested income.

Other issues to bear in mind:

Indices do not include the buying and selling costs, CGT or management costs

The index assumes that the investor is fully committed to the market and holds no cash. In the long term, cash holdings tend to lead to underperformance, but in the short term can improve performance if the market declines

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Property as an asset class can provide returns both from increases to its capital and by providing income, usually in the form of rental payments. Changes in the economy both nationally and regionally can boost prices or bring them down as demand wavers. Of course, many people purchase their main residence which provides a place to live as well as a long term investment. This course, however, considers property purely for investment purposes as follows:

Residential Buy-to-Let – over the past 20 years buy to let has been a popular investment for the regular income as well as the pr...

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...rm returns.  

Advantages of investing in property

Disadvantages of investing in property

Long term capital growth

Upfront costs of Solicitors, Estate Agents and a 3% surcharge on Stamp Duty Land Tax

Regular rental income

Void periods with no tenants or tenants not paying rent (which can lead to expensive legal action)

Availability of tenants

Ongoing management costs of letting the property

Limited opportunity to diversify investments

Which are the two main types of property designed solely for investment purposes?

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Residential Buy-to-Let has been popular for many reasons such as:

Falling yields on equities and bonds making property more attractive

Strong capital performance adding to the appeal

We have already discussed some key issues but it is worth reiterating that an individual wishing to buy this type of property needs to consider liquidity, management of the property, potential tenants and void periods before purchase. Government legislation can also present risks and buy-to-let landlords have been hit by various changes such as:

An extra 3% Stamp Duty Land Tax is paid on top of the normal rates when buying a second property

The 10% wear and tear allowance for furnished lettings has been replaced by allowing landlords to deduct the actual cost of replacing furnishings

Tax relief on mortgage interest is restricted to the basic rate of income tax

Attention should also be given to location, age, condition and adequate diversification of property and other properties/assets within the investor’s portfolio.

Tenure

It is recommended that property owners should always let on assured shorthold leases for defined periods of time. There is no minimum period but they usually run for periods of 6 to 12 months and are not usually subject to rent controls. They usually run for periods of 6 to 12 months and are not usually subject to rent controls. In general, property owners avoid long leases for residential properties as this tends to depress the capital value of the property. The temporary nature of the lease also enables the landlord an opportunity not to renew the lease at the end of the lease period and/or renegotiate the terms.

Expected Yield

When considering the yield that could be derived from these investments, one needs to account for gross rent received, expenses, market purchase price and costs of buying. This can be put into the following formula:

Rental Yield = Gross rent minus expenses/Market price + costs of buying

Expenses which could be deducted from the gross rent include property management fees

Any void periods should also be deducted from the gross rental figure

Costs of buying would normally include solicitor’s fees, estate agent fees, surveys, SDLT and other expenses such as the cost of furnishing the property

Example

Sally bought a rental property for £175,000. She paid legal fees of £1,500, a survey fee of £150 and SDLT of £5,250. She has been renting the property for £800 per calendar month and uses  a Property Management Company to look after the day-to-day running of the property, for which they charge 20% of the rental amount. The Rental Yield on the property is calculated as follows:

Firstly, deduct the cost of the management company from the gross annual rental of £9,600 (£800 x 12): £9,600 – 20% = £7,680

Add up all the initial costs of purchasing the property: Legal fees £1,500 + Survey Fee £150 + SDLT £5,250 = £6,900

Add this amount to the purchase price paid: £175,000 + £6,900 = £181,900

Divide £7,680 by £181,900 and multiply the resulting answer by 100 to obtain a percentage figure

Rental Yield is therefore (£7,680/£181,900) x 100 = 4.20%

NB as Sally bought a rental property she paid an extra 3% in SDLT on top of the normal rates.

Gearing

Gearing is a consideration with a high percentage of purchases, as companies and individuals alike regularly borrow money to be able to afford direct investment into property.

This needs to be taken into account from an affordability perspective, with regards to keeping up to date with the repayments involved as well as the returns required by way of income or capital appreciation to make it a good investment.

Gearing is t...

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... therefore:

Up to £425,000 - 0%

Over £425,000 and up to £625,000 - 5%

Commercial SDLT

The rates are:

Non-residential

Rate

£0 - £150,000

0%

£150,001 - £250,000

2%

£250,001+

5%

Leasing land or premises

SDLT is also charged on the Net Present Value (NPV) of rent payable on a lease:

NPV is calculated by multiplying the annual rent by the term of the lease

Then applying a discount to allow for inflation

And finally deducting the threshold figure (£250,000 for residential property and £150,000 for non-residential)

Where the threshold is not breached, then no SDLT is payable. Where the threshold is breached, SDLT is chargeable at a rate of 1% of the adjusted NVA figure above the residential threshold amount and at a rate of 1% up to £5m and 2% thereafter for commercial leases.

Note: Between 1 July 2021 and 30 September 2021 the nil rate band was £250,000. This reverts to the standard rate on 1 October 2021.

Scotland

In Scotland, Land and Buildings Transaction Tax (LBTT) applies to both residential and commercial property as follows:

Slice of property value - residential

Rate

£0 - £145,000

0%

£145,001 - £250,000

2%

£250,001 - £325,000

5%

£325,001 - £750,000

10%

£750,001 +

12%

Slice of property value - commercial

Rate

£0 - £150,000

0%

£150,001 - £250,000

1%

£250,001 +

5%

First time buyers in Scotland are only subject to LBTT once the property value is more than £175,000.

Purchases of second residential properties over £40,000 are charged an additional dwelling supplement (ADS) of 4% on top of the normal LBTT rates.

Wales

Land Transaction Tax (LTT) is payable in Wales.

Threshold

LTT rate

Up to £225,000

0%

£225,001 to £400,000

6%

£400,001 to £750,000

7.5%

£750,001 to £1,500,000

10%

Over £1,500,001

12%

Land Transaction Tax (LTT) for additional properties in Wales:

Threshold

LTT rate

Up to £180,000

4%

£180,001 to  £250,000

7.5%

£250,001 to £400,000

 9%

£400,001 to £750,000

11.5%

£750,001 to £1,500,000

14%

Over £1,500,001

16%

Land Transaction Tax (LTT) for commercial property in Wales:

Threshold

LTT rate

Up to £225,000

0%

£225,001 to  £250,000

1%

£250,001 to £1,000,000

5%

Over £1,000,000

6%

Letting part of an individual’s main residence

A special exemption exists for individuals who let part of their main residence. The individual must also live there. ‘Rent-a-room’ relief allows a tax-free income of up to £7,500 per annum per property. If the tenant sub-lets the room, then both the owner and the tenant can obtain a maximum of £3,750 rent-a-room relief each.

If the rental income exceeds £7,500 the owner has the choice of paying tax on the excess income above this figure or being taxed on gross income less expenses with no rent-a-room relief in the same way as Buy-to-Let properties.

Property Income Allowance

An annual £1,000 property income allowance exempts income from tax and does not have to be declared to HMRC if it less than £1,000 (before deducting expenses).

Where income exceeds £1,000, the taxpayer can choose to deduct the allowance from gross income to calculate taxable profit, instead of deducting actual allowable expenses.

The allowance will not apply where rent a room relief is given.

The commercial property market is divided into three main sectors:

Office

Retail

Industrial

An investment into commercial property is a specialised part of the overall investment sector and insurance companies and pension funds own a significant proportion of investment property.

Past performance

Property valuations are primarily governed by supply and demand, although there are other factors that also have an impact, depending on the type of property concerned. Supply and demand should not only be looked at in general terms, but also from the perspective of, whether there is sufficient supply and demand for certain types or sizes of property in a given area.

Commercial property prices tend to follow a cyclical pattern and often move in a different direction to equities and sometimes even residential property. Commercial property markets have experienced boom and bust cycles similar to those experienced in the equity markets.

Investment considerations

Income from commercial property, provided it is let to higher quality businesses that have the ability to service rental payments should provide a long term income stream to the investor over time.

Investment will be in the form of retail buildings, offices and industrial properties, which all have distinct features and benefits

Again, the quality of tenant is important as many of these properties only suit a smaller segment of the market

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...% or 20%.

Insurance Company Property Funds

These can normally be held through life assurance funds which specialise in direct holdings of commercial property. The values of units are directly linked to the underlying properties in the portfolios and are established by regular professional valuations. The funds are not geared through borrowing. Liquidity is higher than direct property investment. However, in certain adverse market conditions, units can be suspended for a period of time, halting encashment.

Property authorised investment funds (PAIFs)

Authorised investment funds that invest mainly in property can elect for a tax treatment that moves the tax from the fund to the investor, in the same way as a direct investment in property.

Distributions to investors are split into three types of income: property income, interest income and dividends.

Rental profits and other related income are exempt from tax in the fund and distributed to investors net of 20%. Non-taxpayers can reclaim the tax deducted.

The property income is ring fenced in the PAIF, and other taxable income is subject to corporation tax.

Interest distributions and dividends are paid gross.

Only open-ended investment companies (OEICs) can qualify as PAIFs, so an authorised unit trust would have to convert to an OEIC.

List four ways an investor can invest in property indirectly rather than directly.

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...about this area for the first time:

There are many different options available to investors outside of the main asset classes which can provide additional diversification to an investor’s portfolio. These types of assets tend to follow trends and become more attractive when traditional asset classes are depressed.

With the development and rapid expansion of exchange traded funds over the past few years individual investors now have access to a plethora of new opportunities that were previously only available to institutional investors.  These opportunities cover all sorts of areas and include hard and soft commodities, agriculture, infrastructure and alternative energy.

Commodities

Commodities are raw materials that can be split into two categories:

Hard commodities - those that are mined, such as precious metals, chemicals, iron and oil

Soft commodities - are largely grown, for instance coffee, tea, sugar, wheat; this also includes livestock

Commodity investments are generally considered to be speculative and only suitable for experienced investors due to the additional risks involved. There can be short term supp...

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...icate the object, if the genuineness of the object is called into question this can have a serious impact on the value

Tastes change, which will affect demand

The market for collectibles is often dominated by a small number of buyers and sellers

It can be difficult to diversify and specialist knowledge or advice is a must

Despite these factors, a certain amount of pleasure and enjoyment can be had from a collectible object for the owner

Cryptocurrencies

In simple terms a cryptocurrency, as an alternative to notes and coins, is a digital currency system. The payment processing technology is known as a blockchain which is a digital ledger that processes transactions securely using encryption technology.   Once the transaction is confirmed by ‘miners’ it is permanent and cannot be reversed.

Cryptocurrency transactions are anonymous as the system does not record the name of the person owning the ‘wallet’. They are also not backed by central banks or government and are not regulated by the FCA.

How are commodities classified?

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In this and the previous chapter we have focused on the variety of investments available within the main asset classes of cash, fixed interest, equities, property and alternative assets and the risks and returns of each of them to enable analysis of one investment against another.

In order to spread risk, it is likely that investors would invest in different classes of asset to ensure that they achieve an acceptable level of investment return, whilst at the same time not being over exposed to one particular area. Within the different asset classes this can be achieved by investing:

Acro...

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... of other investments and suggests that they have been chosen on their individual merit as opposed to any links between other investments within the portfolio.

The above points are very important when considering asset allocation and leads to advisers researching the investments available to meet a clients objectives and their attitude to risk. This will be covered in greater detail later in the study text. 

Two investments provide opposite returns in the same market conditions. Are they said to be positively or negatively correlated?

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Your results and the estimated s...

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...ate.

Estimated study time 7.5 hours