Investment Principles and risk. Learning Outcome 1.2, 1.3 & 1.4

Transcription

1 Investment Principles and risk Learning Outcome 1.2, 1.3 & 1.4 By the end of this learning material you will be able to demonstrate an ability to analyse the characteristics, inherent risks, behaviours and correlation of asset classes including equities, property and alternative investments.

2 1.2 Equities Equity is a share in a company. In return for investing in the company, the investor receives a twice yearly dividend payment and hopes to benefit from rises in the share price. Neither of these returns are guaranteed: Share prices are volatile, they go up and down on a daily basis. If the company fails to make a profit, they may not pay out a dividend. If the company ceases trading, the investor can lose their entire investment. The investor is therefore exposed to considerably more risk when he invests in equities than when he invests in cash or fixed interest investments Preference Shares Pay a fixed six-monthly dividend Receive dividend payments ahead of ordinary shareholders Do not entitle an investor to vote Do not have a fixed redemption date Rank ahead of ordinary shareholders in the event of the company s liquidation Types of preference shares Cumulative preference shares Non-cumulative preference shares Participating preference shares Redeemable preference shares If dividend cannot be paid out it when due it can be paid out at a future date. If dividend cannot be paid out when due then it will be lost. If the company s profits grow dividend payments may rise to reflect that. Have a fixed redemption date. Convertible preference shares Give the investor the right to convert their share to an ordinary share at a future date Ordinary Shares: Pay a variable six-monthly dividend based on the net profit made by the company Receive dividend payments after preference shareholders have been paid Entitle the investor to vote (unless they are A ordinary shares which are non voting) Rank behind all other creditors, including preference shareholders, in the event of the company s liquidation Are riskier than preference shares Aviva Financial Adviser Academy v2017

3 1.2.3 Dealing in Shares Trading in shares in the UK takes place on either the London Stock Exchange (LSE) or, for smaller companies, on the Alternative Investment Market (AIM). Both are the primary and secondary markets for shares: The function of the primary market is to sell shares to financial institutions and the public when they are first issued. The function of the secondary market is to allow the shares to be subsequently traded. When an investor purchases shares they will be liable to either Stamp Duty or Stamp Duty Reserve Tax Stamp Duty Stamp duty is payable at 0.5% where the purchase of shares is made using a stock transfer form. The amount due is rounded up to the nearest 5. Colin buys 2,583 worth of shares using a stock transfer form. How much stamp duty does he pay? 2,583 x 0.5% = Rounded up to the nearest 5 is 15..x Stamp Duty Reserve Tax Stamp Duty reserve tax is payable at 0.5% where the purchase of shares is made using CREST, an electronic trading system. The amount due is rounded up to the nearest penny. Let s assume Colin buys a further 2,583 worth of shares using CREST. How much Stamp Duty Reserve Tax does he pay? 2,583 x 0.5% = Rounded up to the nearest penny is xxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxx Aviva Financial Adviser Academy v2017

4 Panel on Takeovers and Mergers (PTM) Levy. A levy of 1 is charged on all purchases that exceed 10, Commission Stockbroker commission is payable on both the purchase and sale of shares. The amount varies depending on the firm used and the size of the transaction. Internet transactions are often the cheapest Direct vs. Indirect Investment in Equities When investing in shares a client has a choice. To invest directly into the shares of one or more companies, or to invest in a collective investment which is a product provided by an investment company that invests in the shares of many different companies. Direct investment has significant disadvantages and advantages. If the client only invests in one company then if that one company goes bust they will have lost all their money. There is no diversification if someone invests in only one company. Investing indirectly through a collective means that their money is invested in lots of different companies, they may benefit from having a professional fund manager decide which companies should be invested in and the risk of them losing all of their money is less than investing directly. Additional benefits of investing via collectives include: Being able to drip feed your savings into the stock market Potentially reducing the costs involved in share ownership Potentially being able to choose a fund that matches your attitude to risk and investment objectives How are equities taxed? Equities are liable to both income tax and capital gains tax: Equities Summary Dividend Income paid gross Income Tax First 5,000 of dividend income: - Tax free as within dividend allowance Dividend income in excess of 5,000: - 7.5% on dividend income within basic rate band % on dividend income within the higher rate band % on dividend income within the additional rate band CGT 10% or 20% after annual exemption Aviva Financial Adviser Academy v2017

5 A higher rate tax payer receives a dividend payment from his BT shares of 6,000. The first 5,000 is tax free as this falls within the dividend allowance. The remaining 1,000 is taxed at 32.5% ( 1,000 x 32.5% = 325). A higher rate tax payer has made a gain on her Unit Trust of 30,000. Assuming she has already used her annual exemption, how much CGT will she have to pay on her gain? 30,000 x 20% = 6, Risk Equity investments are exposed to the following risks: Capital Regulatory Dividend RISK Counterparty Currency Liquidity Aviva Financial Adviser Academy v2017

6 Capital risk Capital risk relates to movements in the share price. The share price depends on the supply and demand for the share by investors Dividend risk The amount of dividend income paid out on an ordinary share is variable and depends on the net profits the company makes (if any) and the proportion of these net profits the company decides to pay out (if any). There are no guarantees. Preference share income has slightly more stability as it is a fixed payment, but the income is still dependent on the company making the necessary profits to pay it Currency risk Where shares are held in currencies other than UK Sterling there is the risk that the may strengthen against the overseas currency. This will reduce the value of any gain made in the overseas currency once it is converted back into UK Sterling Liquidity risk This applies to both direct and indirect investments in shares. The sale of a share is only going to be possible if there is a buyer for it. For shares in smaller companies this may not always be the case. Some collectives, particularly property funds, may have a delay on purchasing shares back from the customer Counterparty risk This is the risk that the company with whom the investment is placed becomes insolvent Regulatory risk Investors who place their capital in regulated investments will have some comeback in the event of the provider becoming insolvent. Not all investments are regulated and the strength of regulations vary from country to country so this additional risk needs to be borne in mind. Aviva Financial Adviser Academy v2017

7 How do we measure performance or share value? Investment ratios can be used to measure share value. An investor can use them to: Spot longer term trends in a company s performance Compare the performance of one company s shares with their peers Investment ratios do have their downsides. These include: All ratios are based on past performance, which may have little bearing on future performance Different companies use different accounting practices, making a direct comparison between them tricky Companies may change their accounting practices over time, making the data unreliable Figures do not take into account inflation Earnings per share Earnings per share (EPS) tells us how much of the company s profit has been paid out to ordinary shareholders. It enables investors to identify trends in the company s profitability. They do this by looking back at previous years EPS s. The EPSs for Howley Plc. for the last 10 years have been: p p p p p p p p p p What does this information tell you about the profitability of Howley s over the last 10 years? We can see that at the start of the decade profitability was falling. This reached a trough in 2010 and has been on a steady upward trend ever since. The formula is: Net Profits attributed to shareholders over number of ordinary shares Aviva Financial Adviser Academy v2017

8 In 2017 Howley s Plc. Has net profits of 2m and 10 million ordinary shares in issue. What is their EPS for 2017? 2m / 10m = 20p. What does this tell us about the profitability of the company when we compare it to the data in our previous example? It tells us that the rising trend is continuing Dividend yield A share s dividend yield tells us how much dividend is being paid out as a percentage of the share price. It enables the income from shares to be compared with other income bearing investments such as cash or fixed interest investments. The formula is: Net dividend per share over current share price as a percentage In 2017 Howley s Plc. declared a total net dividend per share of 8p. Its current share price is What is the dividend yield for 2017? Answer 8p / 1.90 x 100% = 4.21% Dividend Cover This ratio tells us how many times the company could afford to pay the net dividend to a shareholder out of current net profits. The higher the figure, the more likely the company will be able to keep paying a dividend should profits fall in future years. It also suggests that the company is retaining money within the company for reinvestment and/or reserves. If the figure is less than 1, this means the dividend is uncovered. The company is using reserves rather than profits to pay their dividend. This is unsustainable in the long term and should be seen as a warning flag. The formula can either be worked out from an individual investor s point of view or for the company as a whole. Aviva Financial Adviser Academy v2017

9 To work it out on an individual basis the formula is: Earnings per share over dividends per share The work it out on a total profit basis the formula is: Profits attributed to ordinary shareholders over dividends paid to ordinary shareholders. From our previous examples we have already worked out that Howley s earnings per share are 20p and the net dividend per share is 8p. What is the dividend cover for 2017? Answer 20p / 8p = 2.5. This means that the dividend could be paid out two and a half times from current earnings Price earnings (P/E) ratio The price earnings ratio tells us how well the company is regarded in its sector. A company with a higher price earnings ratio is in higher demand, and therefore may be more attractive to investors, than one with a lower ratio. The formula is: Current share price over earnings per share From our previous examples we know that Howley s current share price is 1.90 and its earnings per share are 20p. What is its P/E ratio for 2017? 190/20 = Net asset value per share This ratio is used to show the value of the company. In short, if the company were to stop trading, how much money would be left to pay for each share once all debts had been paid? The formula is: Aviva Financial Adviser Academy v2017

10 Net assets attributable to ordinary shareholders over number of ordinary shares We know from our previous examples that Howley s have 10 million ordinary shares in issue. Let us assume that their net assets are 18 million. What is their net asset value? Answer 18 / 10 = 1.8. This is a positive figure which means that their assets exceed their liabilities Indices A stock market index allows an investor to compare the performance of an individual share or a portfolio of shares with the performance of similar shares grouped together in an index. Indices are available on equities, index linked securities and on Gilts. UK main indices FTSE All Share FTSE 100 FTSE 250 FTSE 350 FTSE Small Cap FTSE Fledgling FTSE All Small FTSE Aim Index series: FTSE All-World Index: Most of the companies listed on the LSE. Top 100 largest companies listed on the LSE. The index is revised every four months with companies coming in and out of the index in March, June, September and December. Prices are updated throughout trading hours, making it a real time index. Next 250 largest companies listed on the LSE. The index is revised quarterly and is a real time index. FTSE 100 and FTSE 250 companies added together. Companies that are listed but are too small to be in the FTSE 350. The index is revised quarterly and is a real time index. Companies that are listed but are too small to be in the FTSE All Share. This index differs from the previous ones we have looked at as it is revised annually in December and prices are determined at the close of business each day. FTSE Small Cap and FTSE Fledgling companies added together. Revised annually in December. Prices determined at close of business each day. A number of indices for companies listed on AIM. These are real time indices which are revised annually. In addition liquidity checks take place quarterly 2,700 stocks from 47 countries. For detailed fact sheets on all of the FTSE indices go to: Aviva Financial Adviser Academy v2017

11 Main overseas indices Dow Jones Industrial Average Standard and Poor s (S&P) Composite. NASDAQ Composite. Nikkei 225 Dax 30 Hang Seng Index CAC General CAC 40 Invitation only index representing 30 companies in the USA. 500 companies listed on the New York Stock Exchange. American technology shares Average of 225 stocks on the Tokyo Stock Exchange 30 largest Germany companies Sample of Hong Kong Stocks Opening prices of Paris cash market Largest French stocks Some downsides of indices include: They may only take into account capital growth and not any reinvested dividend income They do not take into account the investors costs nor their tax situation Some indices, such as the FTSE 100, are made up of a small number of relatively large companies. If misfortune strikes one of these companies it may have a big impact on the index which may not reflect what is happening in the wider markets. The client must choose the appropriate index for any comparison to be valid Who are equities suitable for? Equities are likely to be suitable for those looking for a rising income and / or long term growth and who are prepared to risk their underlying capital to a greater or lesser extent to achieve this. 1.3 Property To add diversification to their portfolio a client may consider investing in property. Property investment offers the potential for real growth i.e. growth in excess of inflation. Returns from property sometimes move in a different direction to returns from equities. This may add an element of protection to a portfolio in times of falling equities although this is by no means guaranteed Residential Property The main way to invest in the residential property market is through Buy-to-let : The investor takes out a mortgage to purchase a property. The property is rented out. The rental income covers the mortgage payments. The investor benefits from any excess of rental income over expenses and any rises Aviva Financial Adviser Academy v2017

12 in the property s value between the time they purchase the property and the time they sell it The risks involved in the Buy-to-let market Liquidity Liquidity risk is the risk of not being able to sell the property either within an acceptable timescale, or at an acceptable price when the investor requires access to their capital Costs Costs are a risk because they eat into the return made by Buy-to-let investors. Costs include: Stamp Duty Land Tax. Estate agents and solicitors fees. Letting property agency fees. Costs of maintaining the property. Stamp Duty SDLT is paid at the rate of tax on the part of the purchase price falling within each of the bands shown in the table below. From 1 April 2016, the rate of SDLT will increase by 3% (for all purchase prices) where someone buys an additional residential property (further information can be found in the Personal Taxation Learning Outcome 1.7). Value of Property Residential rates Additional propertyrates 0 125,000 0% 3% 125, ,000 2% 5% 250, ,000 5% 8% 925,001-1,500,000 10% 13% 1,500, % 15% Over 500,000 (purchased by certain persons including corporate bodies) 15% The amount payable is rounded up to the nearest 5. Aviva Financial Adviser Academy v2017

13 Jessie and Malcolm are looking to buy a second home which they plan to let out. They wish to purchase a property which is on the market for 295, ,000 worth of fixtures and fittings are included in the market price. How much Stamp Duty Land Tax must they pay? 295,000 less 15,000 = 280, ,000 x 3% = 3, , ,000 x 5% = 6, , ,000 x 8% = 2,400 Tax payable = 12,400 Stamp Duty Land Tax is also payable on leases. The amount charged is a percentage of the net present value of the rent payable. That is, the annual rent multiplied by the term of the lease adjusted for inflation: For residential leases if the rent is not in excess of 125,000 then there is no charge. For commercial leases the figure is 150,000. Rents in excess of these figures are charged at 1% Void periods A void period refers to a loss of rent. This can be caused by not having a tenant to occupy the property or by having a tenant who does not pay his rent. Either way there is a loss of income and that will impact on the returns achieved by the investor Minimising risk An investor needs to take care when choosing their Buy-to-let property(ies) so they can maximise their return and minimise their risk. They should ensure that they: Choose an attractive location. Check tenants will be available in the area they have chosen. Decide upon the types of tenants they want to attract. Consider the age and condition of the property and balance the need to buy cheaply with the need to attract tenants and the costs of maintenance. If they are in the position to buy more than one property that they apply diversification principles to reduce risk. They could do this by having properties in different streets and towns rather than all in the same block of flats. Let under assured shorthold leases. Aviva Financial Adviser Academy v2017

14 1.3.3 Returns The expected yield, or return, from a Buy-to-let property is worked out using the following formula: Annual rent less annual expenses over the value of the property plus purchase costs as a percentage. Last year William purchased a property in Grantham for 200,000. His purchase costs came to 6,000. In his first year he has received rental income of 1,200 per month and has expenses of 350 per month. What is his first year s rental yield? 1, x 12 / 200, ,000 x 100 = 4.95% Rent a room relief On a much smaller scale an individual may decide to let out a room in their property in return for a rental income. Providing they continue to live in the property whilst the room is rented out and the room is neither self-contained nor unfurnished, the client can receive up to 7,500 of rental income tax free each year. Where rental income is in excess of 7,500 then the client has a choice: They can choose to pay income tax on rental income in excess of 7,500 with no deductions allowed for expenses. They can pay income tax on the whole amount of rental income and deduct allowable expenses from it. Bertie, a basic rate tax payer, receives 8,500 rental income for renting out a room in his home. There are allowable expenses of 2,000. What tax would he have to pay if he chose to pay tax on just the excess over 7,500? 8,500-7,500 = 1,000 x 20% = 200 What would the correct answer be if Bertie chose to pay tax on the whole amount of rental income? 8, = 6,500 x 20% = 1,300. Aviva Financial Adviser Academy v2017

15 1.3.4 Commercial Property There are three sectors in the commercial property market: Many properties are owned by financial institutions, which then operate collective investment schemes giving individual investors the opportunity to invest in the commercial property market indirectly. Commercial property values are generally cyclical and sometimes move in a different direction to equities and residential property, potentially providing a hedge against falls in these markets. However, there is no guarantee that this pattern will always be the case Characteristics of commercial property market The commercial property market is characterised by: Long term leases which give rise to the expectation of a greater stability of income when compared to the Buy-to let market. Tenants taking responsibility for maintenance and insurance costs meaning that the net rental yield on a commercial property tends to be higher than the Buy-to-let market. Rent reviews taking place every three to five years. Aviva Financial Adviser Academy v2017

16 Downsides of investing in commercial property Downsides include: Property purchase is slow and costly. Infrequent rent reviews limit income growth in the short term. Oversupply will depress prices. Property cannot be sold in segments, its all or nothing Antiques, art and collectibles The capital values of antiques, art and collectibles are subject to different pressures to the capital values of shares, and therefore add diversification to a client s portfolio. Their common characteristics are: They are non income producing assets. There are running and maintenance costs to take into account. Their value is subjective and liable to fashions and tastes changing. Purchases of fakes can wipe out a client s capital. Buyers may be difficult to find when the client wants to sell. CGT will be payable on disposals although they may come under the chattels rules. If the client has the expertise and enjoys a particular type of collecting, then he may well make a profit. However, there is no guarantee and this could be seen as a purely speculative way of investing Private equity Private equity means taking a share of ownership in a business that is not listed on the stock market. It is risky as you are tying your capital up with the fortunes of just one company. The company is likely to be young and growing fast. This makes the investment more speculative, especially considering they are only likely to offer one product or service. To lessen the risk an exit strategy may be arranged beforehand by one of the following methods: Selling shares back to the company. Selling shares on to other investors. Selling shares on to another company. The company being listed on AIM or LSE and trading the shares on there. Retail clients who wish to take advantage of private equity investment but wish to lessen the risks involved, can invest in private equity funds or listed private equity invested companies Aviva Financial Adviser Academy v2017

17 1.4.3 Commodities A commodity can be either hard e.g. metals, oil, coal or soft e.g. cocoa, wheat, sugar. The prices of commodities may not move in the same direction as those of equities and fixed interest investments. Commodities may therefore add diversification to a client s portfolio. Prices are, however, volatile and direct investment is unlikely to be practical for retail clients. Clients wishing to participate in the commodities markets can do so by investing in: Companies which produce commodities. Exchange traded commodities which may invest in derivatives. Funds that invest in commodities. Aviva Financial Adviser Academy v2017

18 Investment Principles and Risk Learning Outcome 1.2 (LO1.2) End of Module Test Multiple Choice Questions Question 1 - Craven is to buy 15,000 worth of ABC plc. Shares via CREST. His broker charges 0.5% commission on share purchases. What will the total charges be in relation to this transaction? Answer A. 75 B. 150 C. 151 D Bagshot Ltd have earnings per share of 15.21p and pay a net dividend per share of 6p. What is their dividend cover? A times B pence C times D. 2.54% 3 - Keji has a large portfolio of shares listed on the Japanese stock market. Which of the following indices could help her to monitor the performance of her shares? A. Hang Seng B. Nikkei 225 C. NASDAQ D. CAC Andrew purchases an apartment for 205,000. He rents it out for 800 a month. His initial purchase costs were 10,000. His allowable expenses are 150 a month. What is his net yield? A. 3.47% B. 3.63% C. 4.09% D. 4.47% Aviva Financial Adviser Academy v2017

19 5 - How can investing in commodities improve a client's portfolio? A. Subject to the client's attitude to risk, they can be used to add diversification to a portfolio. B. Regardless of the client's attitude to risk, they can be used to add diversification to a portfolio. C. Commodities usually move in tandem with equity prices and therefore increase the value of a portfolio in times of rising equity prices. D. Commodities usually move in tandem with bond prices and therefore increase the value of a portfolio in times of rising bond prices. - End of Questions - Aviva Financial Adviser Academy v2017

20 Answers 1 - Craven is to buy 15,000 worth of ABC plc. Shares via CREST. His broker charges 0.5% commission on share purchases. What will the total charges be in relation to this transaction? 2 Bagshot Ltd have earnings per share of 15.21p and pay a net dividend per share of 6p. What is their dividend cover? 3 Keji has a large portfolio of shares listed on the Japanese stock market. Which of the following indices could help her to monitor the performance of her shares? 4 Andrew purchases an apartment for 205,000. He rents it out for 800 a month. His initial purchase costs were 10,000. His allowable expenses are 150 a month. What is his net yield? 5 How can investing in commodities improve a client's portfolio? C 151 C 2.54 times B Nikkei 225 B 3.63% A Subject to the client's attitude to risk, they can be used to add diversification to a portfolio. Aviva Financial Adviser Academy v2017