Investment principles, markets and environment

Main features and types of potential returns

General characteristics

Providing the investment is into a recognised financial institution such as a UK bank or building society or via National Savings and Investments, any capital invested via deposit accounts is exposed to low risk but equally, there is no potential for capital growth. Therefore the real value of the original capital can be eroded by the affects of inflation over time.

Returns will be in the form of interest on the capital invested at the rate offered by the account. The rate can either be fixed or variable (most common). Higher rates can be offered either where larger sums are invested, or where the investor is prepared to give a period of notice before withdrawing funds.

Penalties can be in the following forms: loss of interest for the period of notice required, loss if the difference between say a standard rate and the higher rate of interest provided for larger/longer-term deposits. With National Savings and Investments, no interest may be paid on certain accounts if the deposit is surrendered in the first year.

Returns therefore can be greatly reduced if the investor withdraws funds at short notice or brings funds down to a level where a lower rate of interest is offered.

Nominal and effective rates of return

When comparing two different accounts quoting the same nominal rate, you may find that the effective rate of return is different. This is likely to be because of a variation in the frequency that compound interest is added.

The “effective” rate is the equivalent rate that would be earned if interest is added once a year.

For example, deposit A offers 5.1% compounded annually whilst investment B offers 5.1% compounded half yearly. £10,000 is invested initially:

Deposit A

Deposit B

£

£

Deposit day 1

10,000

10,000

Intere...

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Foreign currency deposits

Accepting attractive rates of interest in foreign currency deposits always needs to be considered carefully as the benefit of higher returns can quickly be wiped out by poor currency exchange rates against sterling.

Equally where currencies are strong, they may appear to be attractive in that the currency gains can offset the lower rates of interest on offer. However, these gains may not be sufficient enough to compensate for the low rates of interest once converted back to sterling.

Some foreign countries do not have the same amount of supervisory control as in the UK so collapse of the deposit taking institution may result in complete loss of the capital investment.

Money market instruments and tradable securities

Large institutions with spare cash may wish to earn returns on these funds whilst retaining the ability to access them at short notice. The wholesale “money markets” provide these institutions with the ability to trade short term “debt”.

Equally some institutions may wish to borrow funds over short terms therefore providing the market for such securities.

There are three main types of security traded:

Certificates of Deposit (CDs)

These give ownership of a time deposit at a bank that pays a fixed rate of interest. Compared to a time deposit account over a similar period (say three months), the investor will receive a slightly lower return but benefits from instant access by being able to trade the CD within the market.

Treasury Bills (TBs)

These are short term loan notes issued by the government.

They last for 91 days.

They pay no interest but instead are sold at a discount so that at redemption date, their face value is paid to holders.

They are highly liquid and because they are backed by the government, deemed to be risk free investments.

Commercial Bills

Issued by companies rather than the government. They operate in the same way as TBs but rates of return are higher to counterbalance the credit risks that can be incurred.

Main Features & types of potential returns

Fixed Interest Securities are loans that are issued by companies, governments and other bodies such as local authorities. Many types of these securities are now available on the open market to suit different types of needs and risk profiles.

They have several common features. In the main, these securities are tradable in that once an investor buys a bond (by doing so he lends money to the borrowing institution), he can then go onto sell it to a third party prior to redemption. This can be done several times before the term of the security ends.

In general fixed interest securities will carry a fixed coupon or rate of interest. Some stocks e.g. index linked gilts, offer a coupon and capital value at redemption that increases with the RPI.

To assess the interest (running/income) yield received from a bond for the price paid, we carry out the following calculation:

Coupon

----------- x 100

Clean price

Fixed interest securities will have a fixed value at redemption (par value).

They will in general have a fixed redemption date at which point the redemption value will be paid.

Some stocks however, are undated with no set term to redemption.

If fixed interest securities are bought at above or below par, the potential if held to redemption, is to make a capital loss or gain.

Bonds are priced on the basis of a value against par for each £100 of nominal (par) value stock purchased. Any amount can be held.

Prices quoted in the financial press are the mid market price (halfway between buying and selling price). They are also “clean prices” in that they ignore the value of any interest that has accrued between each payment date. Interest is calculated daily and must be added or taken away from the purchase price of the stock.

In terms of a required return, the investor will need to choose the type of stock suitable by considering the following factors:

Term to redemption

Level of income yield required

Level of capital gain or loss the investor is prepared to take

The economic outlook

Because the yields from these types of investments both in terms of income received and capital gain or loss are based on the price paid, we need to consider the yield calculations used to determine an acceptable price.

An accurate calculation of yield is to look at the effect of any capital gain or loss at redemption and include this within the overall return.

The gross redemption yield calculation is complex, but a simplified calculation can be used as an approximation. This is called the “simplified gross redemption yield”. The formula is:

Gain or loss to maturity divided by number of years to maturity

------------------------------------------------------------ x 100

Clean Price

Example

A gilt was purchased for £106.90 per £100 of nominal stock.

Assume that the interest (running/income) yield is 4.5% in this case (taking account of coupon payable).

At redemption there will be a capital loss of £106.90 - £100 = £6.90.

There are 3 years to redemption.

Capital loss for each year is £6.90/3 = £2.30.

As a percentage of the price paid the reduction in return is: -2.30/106.90 x 100 = 2.15%

Subtract this from the running yield given above, you have an estimated redemption yield of 4.5% - 2.15% = 2.35%.

The above calculation gives a redemption yield below the running yield. This will demonstrate that the investor will make a capital loss if he holds the investment to redemption.

However, this calculation takes no account of the tax position of the investor.

The “net redemption yield” will...

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Zero Coupon Bonds

Issued by companies at a discount to redemption price. Therefore gain is provided by a return of a higher capital repayment rather than any interest payments.

Its price will rise as the period to redemption reduces but will always trade below par value.

Although it pays no interest, it will still be highly sensitive to interest rate changes as any low coupon bond would be.

4.2.6.2.5 Floating Rate Notes

These securities are issued paying a rate of interest that is linked to a money market rate of interest such as LIBOR (London Inter Bank Offer Rate) which is the benchmark rate of interest for short term loans between banks.

As the rate of interest will be set by reference to LIBOR over 6 monthly periods, it can obviously vary. As a result the price of these securities stays quite close to their nominal value.

Local Authority Bonds

Work within the definitions of qualifying corporate bonds. Therefore no CGT is payable on any capital gains made.

Issued by local authorities although with current Government restraints on spending, there is are restricted amounts of available securities.

Yields tend to be higher than gilts as there is a possibility of default by a local authority.

Stocks are available on a short term basis (just over one year) and longer term or even undated.

Interest is paid net of 20% tax. Non taxpayers can register to receive payments gross.

Permanent Interest Bearing Shares

A fixed interest stock issued by building societies.

They have no redemption date.

Can be traded and are listed on the Stock Exchange.

Capital values sensitive to interest rates.

Rank behind all the building societies other creditors in the event of a liquidation.

Non cumulative interest repayments. Therefore if they are missed there is no obligation to make the payments up.

High minimum investment limits. The market is quite illiquid.

Higher yields provided than gilts due to less security of repayment.

Interest paid half yearly gross but is taxable.

Fall within qualifying corporate bond regime for CGT purposes.

If the building society converts to a bank, PIBs become Perpetually Subordinated Bonds.

Eurobonds

This is the UK market for bonds denominated in other currencies.

Issued in fixed or floating rate note form.

Eurobond market is free form governmental control so many innovative products devised e.g. bonds paying interest in dual currencies, bonds issued with warrants etc.

Interest is paid gross without deduction of tax.

Bond markets

The Primary Market

There are three main ways to issue new bonds:

Auction

Large investors place bids for they amount of stock they wish to buy

Successful bidders pay the price they bid

Individuals can submit non competitive bids for sums up to £500,000 and if successful, they are allocated stock at the average of accepted prices.

Tenders

Bidders place tenders at or above a stated minimum price

The issuer then calculates the price at which the issue would be fully subscribed for

The issuer decides the issue price. Often this will be a little bit below the full take up price to ensure that there the secondary market has an interest after issue

All accepted bidders pay the common price calculated by the issuer.

Direct issues

Issuers are able to sell directly to individual buyers in the market

Normally this method is used for smaller issues and for stock remaining after auctions or tenders

When used for gilts, the stock is known as “tap” stock.

The Secondary Market

The secondary bond market is highly liquid as bond owners frequently change their holdings to reflect changes in:

Income requirements

Changing credit ratings of issuers

Future interest rate trends

Changes to expected levels of inflation

Government finances

The international environment.

Main features & types of potential returns

Equities share some distinct features when defining the types of returns available.

All share classes will provide the ability to receive a dividend in some form, which will be dependent upon profits made.

All share classes will provide the ability for the shareholder to receive an entitlement to capital in the event of the company winding up. Whether the shareholder actually receives anything will depend upon the class of share they own and its priority and the circumstances around the company winding up.

All share classes will provide the ability for the shareholder to have a say in how the company is run although in certain circumstances as we shall see, this can be very limited.

The majority of shares that are listed on a recognised stock exchange (such as the FTSE 100) can be traded. This can therefore give rise to capital gains or losses on sale by the original owner. Some larger unlisted company shares are tradable using 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 less buyers and sellers wishing to make a trade.

History indicates that people wanting to achieve long-term real returns of income and capital but who are willing to accept the volatility surrounding returns, should consider investing in equities.

Key factors affecting price

The expectations of the markets as a whole and investor sentiment in terms of supply and demand will have a great deal of impact on the values of equities.

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.

Volatility

Share price movements in the short term can go quickly up or down.

A lot will depend upon the class of a share and its behavioural features (see variations later on).

A lot will also depend upon the points we made earlier concerning systematic and non-systematic risk.

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Effect of a rights issue

The price of the company’s share after a rights issue will change after the rights issue.

The price of the original shares will fall towards the rights price.

The shares purchased via the rights issue will rise towards the original market price.

An equilibrium will be reached, although, market forces will then influence the overall price level.

Example

A shareholder owns 4 shares with a current market price of £5.00 each – value of £20.

A rights issue is made at £4.00 per share on a one for 4 basis

After taking up the rights, the shareholder now owns 5 shares with a total value for £24

This gives an average price per share of £4.80 which will be the price at which all shares will trade subject to market views on the company’s trading position and prospects.

Adjustment issues

In certain instances, shares are issued for reasons other than to raise capital.

Scrip (Capitalisation) Issues

In some situations the company may decide to reorganise its share capital for instance, where the share price has reached a level which makes it appear unattractive to the markets (e.g. over £10).

A scrip issue will involve the company issuing new shares paying for them out of the company’s revenue reserves. They will therefore be “fully paid” in the hands of the shareholder.

The effect is to increase the ordinary share capital account on the balance sheet and reduce the revenue reserves account.

The share price will fall to its new level e.g. a 1 for 1 issue will cut the share price by half.

The shareholder’s holding in the example above will double, but the value of his shares in total, will not change.

Share Splits

These can also achieve lower share prices but in a different way from scrip issues.

All shares in the UK have a “par” value ranging from 5p upwards. This is for accounting reasons rather than indicating the market value of the share price.

If the company wants to reduce its share price, it can split the issued shares by splitting their par value.

Capital Reorganisations

Capital reorganisations allow companies to restructure share capital in order to return excess capital to shareholders.

A typical approach would be to replace 10 old ABC ordinary shares with nine new ABC ordinary shares plus 10 new ABC “B” shares. These latter shares are often redeemable preference shares for which ABC company offers special purchase arrangements for investors willing to sell. The “B” shares will often be unattractive for shareholders to otherwise keep.

Introduction

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)

One should consider whether date used is 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 may be inaccurate or 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 go on to look at some key measures of company performance.

The following are some commonly used ratios:

Earnings per share

This allows an investor/analyst to assess trends in company’s ability to generate profits.

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.

Dividend yield

This measures the net dividend as a percentage of the current share price.

It allows the investor to compare the returns of a share against other shares or those available from other forms of investment such as deposits or bon...

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These companies are classified as “highly rated” and are often the target of investors seeking low volatility.

However, their high rating is not necessarily a prediction of future performance.

By Sector

The top 619 shares are divided into ten economic groups of 39 industry sectors in total each sector having its own index, collectively the FT Actuaries Indices.

The sectors which are revised cover a range of industries and markets e.g.

Electricity

Food manufacture

Media, Entertainment

Household Goods and Textiles

Banks and Finance.

Sector performance is measured against other data e.g. business cycles to try to identify relationships that can forecast market changes.

Sectors come in and out of fashion mainly with business cycles.

Some sectors are dominated by just a few companies.

Some companies do sometimes move from one sector to another.

By Correlation with the economy

Some shares react to economic changes quickly, others some time after the changes take place.

Some shares exaggerate the degree of any change while others may move in the same direction but to a much smaller extent.

Shares that react in the same ways to economic cycles are known as “cyclicals”. “Counter cyclicals” move in the opposite direction to the economy.

By Currency

Many companies derive their profits from overseas operations so will be susceptible to changes in exchange rates both in terms of what is actually “earned” overseas and when funds are converted back to sterling in bringing them home to the UK.

Introduction

Under the Companies Act 1985, all companies are required to file annual accounts with the Registrar of Companies at Companies House.

The main documents required in the accounts areas follows:

A profit and loss account

A balance sheet signed by a director (who must be named)

An auditors report signed by the auditor (small private companies with turnover of not more than £6.5 million are generally exempt from this requirement)

A director’s report signed by a director or the secretary of the company

Notes to the accounts

Group accounts (for groups of companies).

The accounts need to be approved by the board of directors and signed before they are sent to Companies House. They do not need to be approved at a general meeting of the company or agreed with HMRC before filing. The legal responsibility for filing lies with the company’s directors.

Accounts filed by small and medium sized companies can contain less information than is required for larger companies. However, all companies must supply a full set of accounts to shareholders.

Public Limited Companies must file accounts within 7 months of the end of their accounting period. For private limited companies, the deadline is 10 months. Special conditions apply to a company’s first accounting period where the deadline can be extended. Where a company has a first accounting period of less than 12 months, the 7 (or 10 month) deadlines still apply.

Accounts filed at Companies House become publicly available documents. They can therefore provide investors with detailed information about a company and enable them to perform relevant investment analysis. They can also be used to assess the financial well being of the company. This is particularly useful for businesses who wish to trade with the company.

The Profit and Loss Account

This shows what has been sold in the trading period, how much the sales have cost and what profit has been made. It can also show any transfers that have been made (if at all) from the company’s reserves and any dividends paid or proposed.

These statements are usually produced for 12 month timescales although this can vary in the first trading period or where the accounting date is changed. In addition, many companies produce more frequent statements e.g. monthly, quarterly in order to measure the company’s performance against targets and budgetary constraints.

Businesses can pay out all profits as dividends to shareholders. Alternatively (and more usually), some profits can be retained in the business for future reinvestment or to build up general reserves.

Sales will include goods and services sold but not necessarily paid for. They are not therefore the same as cash receipts.

Purchases include goods and services bought but not necessarily paid for.

Accounts therefore are carried out on what is known as an “accruals basis”.

As can be seen from the example later on in this module, there are various types of profits which can be of interest to different analysts.

The Balance Sheet

This is a statement of a business’s assets and liabilities at a particular point in time. It shows what the company owns and what is owed. The difference between the two is the company’s overall net worth. This amount effectively belongs to the company’s shareholders.

Assets

There are two main types of assets:

Fixed assets e.g. buildings, plant and equipment

Current assets e.g. cash, short term investments, stocks of materials, finished goods, work in progress and debtors.

Liabilities

Again these are separated into two main categories:

Current liabilities i.e. amounts owed by the business which fall due within one year. Examples could include payments due to suppliers, overdrafts, tax etc

Long-term liabilities i.e. amounts due to be repaid after more than one year.

Net Current Assets

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Current assets/current liabilities

Kingpin Leisure plc current ratio = 3,504.5/2,464.0 = 1.42:1

The current ratio measures the extent to which the claims of short-term creditors can be covered by short-term assets. Short-term liabilities are those that fall due within 1 year.

Different sectors will have different acceptable ratios although generally a ratio of between 1.5 and 2 would be considered satisfactory.

Liquidity (quick/acid test) ratio

Current assets – stock/current liabilities

Kingpin Leisure plc liquidity ratio = (3,504.5 – 500.2)/2,464 = 1.22:1

The liquidity ratio measure the extent to which the claims of short term creditors can be paid quickly without having to raise additional capital or sell fixed assets.

Generally the liquidity ratio should be at least 1 although will vary depending upon the type of business. Companies with quick turnover of stock generating cash sales and purchasing on credit can have a liquidity ratio of less than 1.

“Z” score analysis

The “Z” score analysis combines a number of special ratios which help to not just analyse current cash flow difficulties (as with the previous two ratios), but also whether the organisation is on the brink of financial collapse.

It is reasonably accurate in its predictions of potential collapse (70-80% within one year), but less so over longer periods such as five years or more.

Working capital management

Working capital (or net current assets) should be investigated further if there are large differences to previous figures particularly if they are detrimental.

The ratios commonly used to analyse working capital management are as follows.

Debtor turnover

Measured as sales/debtors.

With Kingpin Leisure, debtor turnover is 9205/2104.2 = 4.37 times.

The debtor turnover can be looked at in terms of numbers of days Kingpin takes to collect money from customers. Here the formula would be debtors/sales x 365.

For Kingpin Leisure plc this would be (2104.2/9205) x 365 = 83.44 days.

On average, Kingpin Leisure plc is taking 83.4 days to collect money from its customers. With a usual acceptable benchmark figure of around 60 days, Kingpin Leisure’s debt management should be investigated further.

Stock turnover

Measured as cost of sales/stock.

With Kingpin Leisure plc, stock turnover is 5600/500.2 = 11.20 times

This would imply that Kingpin Leisure plc holds stock on average for about 32.59 days (365/11.20). Comparison of this length of time would have to be made with other businesses working within the sector.

Creditor turnover

Measured as cost of sales/trade creditors.

With Kingpin Leisure plc creditor turnover is 5600/2464 = 2.27 times.

The creditor turnover can be looked at in terms of numbers of days Kingpin takes to pay money to creditors. Here the formula would be trade creditors/cost of sales x 365.

For Kingpin Leisure plc this would be (2464/5600) x 365 = 160.6 days.

On average, Kingpin Leisure plc is taking 160.6 days to pay money to creditors. These extended credit terms are good for managing working capital in the business provided creditors have agreed to accept them.

Operational efficiency

Consideration needs to be given to the company’s operational management to compare it with other companies in the sector. Generally the more efficient the management, the greater the profits will be.

The company’s ability to manage staff resources can be assessed by the following:

Sales per employee: sales/number of employees

Wage costs as a percentage of sales: wages/sales

The company’s efficiency of managing sales overheads can be assessed by the following:

Administrative costs/sales

Distribution costs/sales

The company’s efficiency of managing assets can be assessed by the following:

Sales/fixed assets + current assets

Sales/stock

Net assets of Employees

Research and development/sales

Good operational management is a balancing act. Investors will be concerned about the company’s ability to grow profits over years and consistently perform well in good and bad times.

Main features & types of potential returns

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 or bring prices down as demand wavers.

Residential property investment in recent years has become popular due to the combination of lower returns from other asset types, the easier availability of buy to let mortgages and strong capital growth of property values.

Commercial property investment has often been used as the main type of property investment for larger funds where businesses have to maintain the costs of rent as a fundamental part of running their organisations.

Property investment can present certain disadvantages in that it can be costly both to purchase and manage on an ongoing basis, there could be periods where no tenant can be found or there are defaults on rent. It can also be illiquid i.e. difficult to buy or sell in terms of time and supply and demand.

Volatility

This will depend upon the economic conditions over a period and the quality of tenants. Property analysts will tend to foresee where conditions are improving or getting worse and buyers and sellers keeping a close eye on trends can have a little time in which to make decisions. However, those not taking all factors into account can suddenly suffer nasty shocks if prices start to spiral either way.

As an example, if the property is in an area already charging high rents on average, then the landlord letting out to a student will be charging out even higher sums to compensate for the possible risks involved. Yields will be high, but what if the student defaults on rental payments due to lack of available funds? Added to that, the economy slows down and there is a glut of rental property on the market meaning that the landlord can’t find a new tenant. Income effectively dries up until the property can be rented out again. Further as there is over supply of these properties, many owners decide to sell at a rate above demand with the consequence that prices start to fall again.

The effects of this movement in price can be drastic if the owner is looking to make short term gains, but like other assets backed investments, if the longer-term view is being taken, then economic recovery could bring in new good quality tenants and increased property values as demand rises. This would smooth out eventual returns. Note however, that historically returns have not been much above the rate of inflation on average over long periods.

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As already mentioned, property bought and sold directly is illiquid. Therefore the buying and selling process cou...

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REITS contain a ring fenced property letting element which is exempt from corporation tax and a non ring fenced element which contains activities separate from property letting e.g. provision of property management services. Profits from this latter element are subject to corporation tax at 28%.

Under the new rules for REITs, no corporation tax is payable within the fund’s “ring fenced” property letting element providing that at least 90% of rental profits are distributed to shareholders.

In addition, in order to enjoy its taxed advantaged status, a minimum of 75% of the REIT’s total gross profits, must come from the ring fenced element.

REITs can be held in both ISAs (individual savings accounts) and SIPPs (self invested personal pension schemes).

This new investment trust provides investors with far greater access to the property investment market without the liquidity risk associated with holding such investments directly.

REITs will be quoted on the London Stock Exchange like other investment trusts and dealt in the same way.

For investors, where distributions are made from the tax-exempt element of the REIT, the income received will be treated as property income and taxed at 20% at source. Non-taxpayers will be able to reclaim this tax, with higher rate taxpayers having a further 20% to pay. Distributions made from the non tax-exempt element will be treated as dividends and taxed in the usual way as any other UK dividend.

Capital gains made by investors on REITs will be subject to CGT in the usual way.

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.

Authorised Property Unit Trusts

These have a similar nature and intention as life company funds but have generally not proved that popular with investors to the extent that few funds are available on the market. Due to the tax treatment of unit trusts and OEICs, capital gains within the fund are likely to be more tax efficient than life company funds although one needs to bear in mind the ultimate CGT consequences to the investor on disposal. Since 2005, FSA authorised unit trust property funds could within an ISA wrapper.