Equities are important to the private investor. Here are some important
aspects and definitions:
Bellwether stocks
A US term for blue chip stocks.
Biotechnology companies
Biotechnology companies are a high-risk investment. Fewer than 10 per cent of
their products reach clinical development. If a company has a number of
products in its pipeline, some with a large market, the failure risk is
lower. Once production has leapt early hurdles, the success rate improves.
Blue chips
This is a generic term for large, reputable companies that lead the market and
are traded in large quantities by institutional investors. In the UK, the
100 companies included in the FTSE-100 index are so described.
Traditionally, blue chips have been regarded as safe investments, although
they can sometimes be volatile, particularly in the high-tech sector. Blue
chip stocks generally pay dividends and are regarded favourably by investors.
Bottom fishing
Bottom fishing is the search for bargain stocks whose prices have fallen so
low that they now represent good value, even if the company’s short-term
prospects are not great.
Bottom up
The bottom-up investor focuses as a priority on the fundamentals of individual
companies first and only secondarily on industry and economic trends. US
fund manager Peter Lynch famously works this way. The opposite approach is
top down.
Buffett, Warren
Warren Buffett is chairman of US insurance group Berkshire Hathaway, and is
said to be worth over US $30 billion from his investing. He is mainly a
value investor, and was heavily influenced by Benjamin Graham.
He invests in long established companies with a strong franchise, and the
ability to generate earnings. He considers such ratios as return on equity,
profit margin and gearing. He looks for a company to have an intrinsic value
of 25 per cent or more above its market capitalisation.
As a long-term investor, Buffett sees himself as an owner in his chosen
companies and is concerned with how they succeed as a business. He does not
much consider market conditions, timing, or stock supply and demand.
Bulls and bears
The terms ‘bull’ and ‘bear’ describe how investors expect the stock market to
perform. Bulls are optimistic about the stock market or individual stocks,
and bears are pessimistic. The terms may have arisen because bulls toss
people up, while bears knock them down. The consensus market view will be
reflected in trading activity and to a large extent becomes a
self-fulfilling prophecy.
Burn rate
The burn rate, also known as the ‘cash burn rate’, is the speed at which a
company uses up cash. The term is often, but not exclusively, applied to
biotechnology companies.
Business-to-business
This describes a business model where the company provides goods or services
for another company rather than for a consumer. In the case of internet
companies, this business model exploits the internet’s order-taking and
service facilities without using a middleman, and is considered to have high
potential.
Business-to-consumer
This describes a business model where the company provides goods or services
directly to the public. Within e-commerce, it is the least proven model.
This type of internet company must buy items from producers and store them,
and so it pays middlemen for inventory space and for extra administration.
Market leaders such as Amazon, the online bookseller, are best placed to
survive.
Buyback
This is when a company buys back its own shares from the shareholders. The
move might be seen as positive for investors in that it will reduce the
number of shares in issue and so increase the earnings per share. It is also
a way for investors to sell their shares without incurring such costs as
broker’s fees that would apply if they sold in the open market. But a
buyback is only possible when a company has a surplus of cash, and it may
suggest that it has nothing better to do with it.
Cockroach theory
The cockroach theory is that, if bullish or bearish news arises, further
developments will reinforce the message. The underlying premise is that
cockroaches come not singly but in groups.
Consumer-to-consumer
This is the business model for companies that match one consumer with another.
In the case of internet companies, it is considered to have high potential
because it takes in revenue but does not hold inventory.
As a consumer-to-consumer business, US-based online auctioneer eBay has been
profitable since it went public in the autumn of 1998, bucking the
loss-making trend of most quoted internet companies in their early years.
Cyclical companies
Shares in cyclical companies rise and fall quickly with economic conditions.
House builders, resource companies, or paper and car manufacturers are in
this category. For example, when the economy is strong, house builders will
benefit from the accompanying housing boom, but in weaker economic
conditions, demand for housing can go down. Resource companies often do well
in spring and summer but not at Christmas.
EPIC code
This is a three or four letter symbol for individual stocks. To obtain a price
quote from your online broker, you may be asked to key in the EPIC code on
its website. Most brokers will offer a search facility to enable you to look
up the EPIC code if you do not know it by entering the company name.
Ex-dividend Day
Ex-dividend Day is the date on which a UK company pays a dividend. As the date
approaches, the share price will rise slightly in anticipation of the
payout. When the dividend has been distributed the shares become
ex-dividend, and the price will slip back a little.
Eyeballs
This refers to the number of visits a website. In the dot com boom of 1999 and
early 2000, technology analysts measured eyeballs for internet companies.
But, as experience has shown, frequency of visits to a website is not always
correlated with revenue.
Graham, Benjamin
Benjamin Graham was a US-based mathematician and classics enthusiast who first
developed the concept of value investing in the 1920s. He said that a value
investor should select shares as if buying the entire underlying company.
Among other criteria, the company should have small gearing and a low P/E
ratio, and the dividend yield should be at least two thirds of the company’s
AAA bond yield.
He also specified that the company should have a market capitalisation of two
thirds or less of its quick assets (current assets, excluding stock, less
current liabilities). After it has risen to 100 per cent of these, the
investor should sell the shares.
The criteria set by Graham are tougher now than in his day and, in a bull
market, often impossible. He explains his methods in detail in his classic
books, The Intelligent Investor and Investment Analysis.
Greater fool theory
This theory suggests that, if you overpay for a stock during a speculative
bubble, the price will rise still further because a greater fool will pay
more. The downside of the theory is that the fools eventually stop buying
and the share price plummets as everybody rushes for the exit.
Growth investing
The strategy is to buy stocks that are growing fast, either before, or soon
after, the market has recognised their potential. A selling strategy is also
important.
The March 2000 crash in high-tech stocks drew attention to the risks of buying
stocks with a high turnover and no earnings, or not much of either.
Some fund managers select stocks on the principle of GARP -- growth at
reasonable price -- which combines growth and value. A useful ratio for this
is PEG. Two great growth investors are Peter Lynch and T J Rowe Price.
High yield investing
The strategy is to buy and hold high yield stocks. The yield is the net
dividend as a percentage of the share price. High yield investors buy stocks
that have fallen out of favour, reflected in a yield that has risen
proportionately to a decline in the share price. The market is likely to
have overreacted and the shares could recover, making a capital gain. Until
that happens, the yield should be handsome.
The risk is that a low stock price may not indicate value. The share price may
fall still lower, particularly if the company’s problems are long-term. This
has happened at various times with blue chip companies such as Marks &
Spencer, Shell, and British Telecom, although companies of this strength and
size tend to recover.
If a stock plummets in value, it is not much compensation to have a high
yield, although high yield investors have learnt to take a longer view. High
yield investment methods such as the O’Higgins system involve periodically
selling dud stocks in your portfolio, as well as reinvesting dividends.
Infrastructure companies
Infrastructure companies provide the internet sector with services ranging
from software to web design. They have more reliable revenues than other
internet companies and so had a better survival rate following the March
2000 collapse of high-tech companies.
International equities
Trading in international equities from the UK became easier after exchange
controls were abolished in 1979. You can now trade US or continental
European equities through many UK brokers, in some cases as cheaply as
trading UK stocks. To invest elsewhere in the world, you may need to use
local brokers, which could create hurdles.
If you trade shares in emerging markets such as China, Poland, Turkey or
Russia, the risks are high but so are the potential rewards. There may be
liquidity or settlement issues. To spread the risk of investing outside the
UK, you can buy unit trusts including in emerging markets.
If you invest in companies listed as American Depositary Receipts (ADRs) in
New York or Global Depositary Receipts in London, the risks are less. The
reassurance factor is that the company will have been required to meet
international standards of transparency, accounting and other aspects of
corporate governance. It is likely to be a large company.
However, the 2004 decline of US-quoted Russian oil giant Yukos, listed in the
form of ADRs on the New York Stock Exchange, shows that very real risk
remains. Yukos was regarded as the model Westernised Russian stock until it
was hit with fraud claims.
January effect
This is the relative out-performance of stocks in January. Over decades, it
has manifested itself in UK and US markets.
Lynch, Peter
Peter Lynch is a master growth investor, who managed Fidelity’s Magellan Fund
in the US for 13 years. He has a bottom up investment strategy.He has
focused on companies with both high earnings growth and a winning business
formula. The business model is more important than the strength of
management. Lynch has invested for the long term, selling only on stagnation
of growth.
A typical Lynch-style investment might be in a company with earnings that have
temporarily declined, and a share price lower than net asset value, but with
an improving financial status. Companies with slow or average earnings
growth and cyclical companies are to be avoided.
Momentum investing
The momentum investor focuses on timing, aiming to take advantage of upward or
downward trends in the share price. The theory is that the stock price will
continue to head in the same direction once it has started to move because
of the momentum behind it, driven by the presence of a large number of
investors in the market who will buy a stock that is moving up.
The buying trigger may be a change in analysts’ forecasts, or in relative
market strength. Momentum addicts will continue to buy as long as everybody
else does but will sell when the turnover slackens. The trick is to do the
same.
A key component is volume of shares traded. If a share goes higher and higher
on declining volume, it is a bit like Tom and Jerry running poised for that
precious second after they have run over the cliff and before they fall, as
a fund manager put it to me.
O’Higgins system
The O’Higgins system is the best known of the high yield investing methods.
Michael O’Higgins, a fund manager based in Albany, New York, popularised the
system, which is based on investing in selected large blue chip stocks in
the Dow Jones Industrial Index in the US.
To apply the system, open a cheap, execution-only account with a stockbroker.
Invest in either the 10 highest yielding stocks in the Dow Jones, or in the
five of these with the lowest closing prices. Hold qualifying stocks for the
long term, reviewing your portfolio once a year, replacing stocks only if
new ones qualify. Reinvest all dividends.
The system has a track record. In 1973--91, the five highest yielders with the
lowest share prices in the Dow Jones outperformed that index for 15 out of
the 19 years. Since then, the system has worked less well.
Online content companies
These companies specialise in collecting and producing online content. The
business model is not yet properly proven. People who will pay for
newspapers or TV will not always pay for similar material on the web.The
online content companies may rely more on advertising and user list rentals
than subscriptions. Many are loss-making. Yahoo!, the US internet search
engine, is a frequently cited exception.
Ordinary shares
To own ordinary shares in a company is to have a stake in it. The shareholders
are entitled to vote at annual general meetings.
Pari passu
When new shares in a company carry equal rights to those of its shares issued
earlier, they are pari passu. It means of equal rank.
Penny shares
Penny shares are low priced. There is no defining price boundary but, in the
UK, penny shares are seen as costing up to about 50p or £1.00, depending on
your view, and in the US, perhaps up to US $5.00. They tend to be shares
with a small market capitalisation.
There is often one main market maker in a penny stock, and others may follow
its lead. The spread tends to be wide and investors can deal only in limited
sizes, perhaps 5,000 or 2,000 shares. If investors try to sell many shares,
the market maker may drop the bid price significantly as a deterrent.
A penny stock moves mainly on news and rumours. If the market gets hooked, the
share price may soar higher than fundamentals justify. If company or market
news is adverse, the share price may fall sharply. But the company is more
likely to get taken over than go bust. Because they are so speculative,
penny stocks should occupy only up to 15 per cent of an investor’s equity
portfolio. Even then, it is safer to spread the risk over several penny
shares, including growth and recovery situations.
Successful penny share investors tend to pick their own stocks. Avoid the
specialist penny dealers. They try to offload shares in dubious or troubled
companies that they have bought up cheap. Stockbrokers interested in small
companies can give advice, but at this end of the market it can be geared
towards generating commission.
Preference shares
Preference shares carry a fixed dividend which is paid before dividends are
paid to holders of ordinary shares. They have priority over ordinary shares
if the company has gone into liquidation. They own part of the company but
have no voting rights.
There are various types of preference share. Cumulative preference shares
accumulate dividend arrears and carry them forward, but non-cumulative
shares receive dividends only if the company pays them. Convertible
preference shares may be switched after a fixed term into ordinary shares,
and redeemable shares pay the investor the nominal value of the shares on a
specified date. Zero coupon preference shares pay no dividend.
Price, T Rowe
T Rowe Price was one of the great US fund managers in the 1930s to the 1950s.
He was a growth investor with a top down investment strategy. After choosing
a suitable sector, Price sought companies with a competitive advantage,
including strong management and patents and sound research. He favoured a
rising earnings per share, a high and a rising profit margin, and a sound
balance sheet.
Price would sell stocks in a bear market or if growth prospects had subsided.
Should a stock that he owned rise to a higher price than he would be willing
to pay for it, Price would sell 25 per cent. If the stock rose still higher,
he sold more.
Real option pricing
Real option pricing is a technique of valuing a share based on the underlying
company’s potential reaction to a range of scenarios. In the run up to the
March 2000 stock market decline, real option pricing was often used to value
high-tech stocks. It gave too many over-optimistic recommendations based on
unreliable information fed into the models.
Real time prices
Real time prices are valid at the time of publication. They are available free
of charge through some online brokers and through Teletext
(www.teletext.co.uk).
Recovery stocks
These are out-of-favour stocks that show potential for returning to, or in the
direction of, former glories. It could happen if the underlying company
becomes a takeover target. See also the next entry, ‘Shell company’.
Shell company
The shell company has low-priced shares and little or no business of its own.
It is a form of recovery stock (see previous entry). Its share structure
enables new management, perhaps already a substantial shareholder, to seize
control.
Stamp duty
Stamp duty is a tax that the UK government levies at 0.5 per cent every time
that you buy shares. It is also payable on property. It is a constant gripe
that UK stamp duty is more expensive than in continental Europe. Stamp duty
does not apply on purchases of North American or most European stocks. You
will also avoid it if you trade contracts for difference or place spread
bets.
Stock screeners
Stock screeners enable investors to set valuation perimeters such as for the
P/E ratio or dividend yield, and to view a list of stocks that fit.
Stockbroker
Stockbrokers buy or sell shares for investors. They vary in their approach,
but the more personal the service, regardless of how good it is, the more
you are likely to be charged for it. Stockbrokers are advisory,
execution-only or discretionary. There are also the boiler rooms. Let us
take a look at each:
Advisory
Advisory stockbrokers advise clients on which stocks to buy or sell, and when.
Some specialise in certain types of stock, and levels of expertise vary
enormously.
Online
The execution-only broker does not advise on which shares to buy but simply
executes orders. By this limitation on its services, it reduces staff and
other costs and passes the savings on to the customer. Execution-only
services are provided both online and by telephone, and charges are
typically a fraction of those associated with using an advisory or
discretionary broker.
The cheapest online broking service offers a facility for you to buy or sell
shares by e-mail. The firm will accumulate trades, and then place bulk
orders. This is for occasional investors. The disadvantage is that you could
be hit by price volatility between when you placed your order and when it
was executed.
The browser-based broker provides a faster service. It offers investors a
facility for executing a trade themselves via the internet. They may deal at
a price shown on screen through a connection with the London Stock Exchange.
The active trader broker provides software with a facility for fast trade
execution, and will not ask for order confirmation, as some browser-based
brokers do. Clients of brokers that operate primarily online may find that,
if trading becomes busy, long telephone waiting times can occur.
Discretionary
Discretionary brokers take full charge of an investor’s portfolio, and to make
this worthwhile, it needs to be substantial. They make buying and selling
decisions on the investor’s behalf for a fee. There may also be a trading
commission, which gives the broker an incentive to review the portfolio, but
it should not be so high as to encourage overtrading. The charges overall
are lower than on unit trusts.
There are some good discretionary brokers and some bad ones. Following the
March 2000 stock market decline, bad discretionary fund management produced
unfortunate results. Even in early 2005, many discretionary portfolios
invest 80 per cent of funds into equities, which are a high risk asset
class, for retired clients who need defensive portfolios.
Some discretionary brokers overtrade portfolios. If the fund is completing
40--50 trades a year, this is the level at which the broker often receives
commission. Investors should never leave everything to the broker, but
should ask questions and request frequent statements.
Boiler rooms
Boiler rooms push dubious or non-existent shares or other investments on
gullible members of the public by telephone and the internet. Even if the
shares do exist, they are likely to be subject to restrictions which make it
impossible for the purchaser subsequently to sell them. These outfits now
operate mostly from outside the UK.
Clients of the boiler rooms will often lose all their money, and they have
little recourse. Investors in firms unauthorised by the Financial Services
Authority have no access to the Financial Services Compensation Scheme or,
for making a complaint, to the Financial Ombudsman Service. Some
jurisdictions make no effort to stop local businesses ripping off clients
based outside the country.
Even when the investor has lost money on shares the game may not be over. An
operation may cold-call the investor and offer to attempt to recover the
cash invested in return for an upfront fee. In reality, it may be linked
with the original fraudster, and the recovery operation a fraud.
The FSA publishes on its website (www.fsa.gov.uk) a warning list of
unauthorised firms selling financial products into the UK, but it tends to
be incomplete. The FSA consumer helpline receives 100 calls a month from the
public about boiler rooms.
In the summer of 2004, the FSA conducted a survey of 105 victims who had
called the helpline. It found that 87 per cent of them were male, 44 per
cent were aged 35--55, and 42 per cent were over 55 years old. About 41 per
cent of the callers had been investing for over 10 years, which, according
to the FSA, dispelled the myth that it is only the novice investor who
becomes a victim of investment scams.
Ten bagger
A ten bagger is a stock whose price rises tenfold. The word derives from
baseball terminology. US fund manager Peter Lynch first applied it to stocks.
Top down
The top-down investor focuses on economic and industry trends first, and the
fundamentals of a company last. The opposite approach is bottom up.
Value investing
Value investing is buying stocks at below fundamental value and selling when
they become expensive.
How to Understand the Financial Pages is written by Alexander Davidson,
published by Kogan Page, costs £14.99 and can be purchased from
kogan-page.co.uk
