INVESTMENT IN SHARES

| INVESTMENT PRINCIPLES |

Why invest?
Tools to make compound interest work

knowledge and time. Investor B invests R2 000/year each year holders worldwide have seen a signifInvestors need perseverance to stick to from age 19 to 26. He then stops investing but icant amount of the value of their their investing plan even when the markets are leaves his R14 000 nest egg, earning 10%/year investments in shares evaporate over the past a little bit rocky, as compound interest works interest until he retires at 65. At that point his few weeks. Against that background the nest egg will be worth R944 641. 20 YEARS AVERAGE ANNUAL RETURN - BEFORE & AFTER TAX (1985-2005) man in the street will be wondering why Though the total is slightly less than they should bother with investing in Return, % that of Investor As savings, its clear Before tax After tax shares on the stock exchange. that Investor B has actually made more 25 In a nutshell, the simple answer is money from a far smaller investment. 19,7 19,3 19,8 20 that investing in shares is a good way to The six years head start in investing 18,0 16,6 16,6 create long-term wealth for any individmore than offsets the bigger contribu13,9 13,6 15 12,7 ual. Simon Pateman Brown, MD of tion (in rand terms) made by Investor A. 12,2 SAWarrants, says that the stock market Thats the power of compound interest 9,2 9,3 10 7,8 outperforms any other asset class over and shows why investors need time. 6,8 5,2 the long term. As the graph shows, equiWhile many individuals are already 5 ties (or shares) produced an average tapping into the stockmarkets wealth 19,3% return after tax each year creation potential through products 0 Equities Own Bonds Property Inflation Part Fixed Krugerbetween 1985 and 2005. That compares such as unit trusts, they can maximise mortgage (20yr) unit bonds deposit rands trusts (1yr) favourably to the average annual returns the value they receive by reducing Source: JPMorgan of other asset classes over the same costs. timeframe, such as own mortgages In week three of this series well (16,6%), 20-year bonds (13,6%), property unit over the long term. Second, investors need show how just a small upfront saving of a few trusts (12,7%), participation bonds (7,8%), intelligence, as they must know what theyre percent makes a real difference to the longone-year fixed deposits (6,8%) and Kruger- doing and why. Over the next 12 weeks this term result due to compound interest. rands (5,2%). series will give readers some of the tools they Richard Seddon, head of Online Share Its important to note that investing in need in that regard, as well as pointing them to Trading at the Standard, says that the potential shares has also resulted in creating real wealth, other sources of knowledge. for returns through direct investment in shares as inflation has averaged 9,3% over the same The knowledge that investors need to make is greater than that in a simple savings account period. wise investment decisions comes from under- or a unit trust. Wealth creation occurs when a sharehold- standing how the mathematics works. The table Thats because direct investment cuts out er buys shares at a low price and sells them at illustrates the difference between two investors the costs associated with products such as unit a higher price in the future. The magic who begin saving at different ages. trusts. behind shares superior wealth creation is Investor A starts saving R2 000/year from However, wealth creation (or capital making the money do the work. Thats called the age of 26 until retirement at 65. Over his growth) isnt the only reason to invest in compound interest. Investopedia defines lifetime hell invest R80 000. Assuming inter- shares. compound interest as: The ability of an asset est at 10%/year his nest egg will be worth Shares can also be bought to generate to generate earnings, which are then reinvested R973 704. income. Shareholders earn income from their in order to generate their share investment, as they own earnings. In other > INVESTOR A (VD) AT 10% INTEREST + GROWTH INVESTOR B (VD) AT 10% INTEREST + GROWTH receive dividends. Diviwords, compound interest dends are payments (either Age Contribution Year-end value Age Contribution Year-end value refers to generating earnhalf-yearly or annual) that 19 R0,00 19 R2 000,00 R2 200.00 ings from previous earncompanies make from the 20 R0,00 20 R2 000,00 R4 620,00 ings. Though it may not profits they declare. sound like much, over time Whatever your reasons 26 R2 000,00 R2 200,00 26 R2 000,00 the interest on interest for investing its never too 27 R2 000,00 R4 620,00 adds up to a significant early to start. Over the next 28 R2 000,00 R0,00 amount of money. 12 weeks this series will 65 R2 000,00 R973 704,00 65 R0,00 R944 641,00 Investors need four give the novice investor Total Total tools to make compound some tools to take charge Contribution (R80 000,00) Contribution (R14 000,00) interest work for them: of his or her own financial Return R893 704,00 Return R930 640,00 perseverance, intelligence, destiny.
6 JULY 2006 FINWEEK 1

ARKETS ARE FALLING and share-

INVESTMENT IN SHARES

| SUPPLY & DEMAND |

What drives share prices?

Quality companies always rise to the top.
INVESTING ISNT GAMBLING, says Simon Pateman Brown, MD of SAWarrants. He notes that gambling is putting money at risk in the hope that youll make more money
level where buyers and sellers agree on a value. In times when more people want the shares, demand is high and supply is likely to be limited, as existing sharePrices are set at holders will want to hold onto the level where their investments. That will buyers and result in an increased share sellers agree on price. Conversely, the share a value. Richard Seddon, price will drop when fewer people want to own the share (which head of equals lower demand) and there Online Share Trading at the are more sellers (higher supply). Standard In turn, supply and demand will ultimately be driven by other factors, including the outlook for general economic growth, the investors opinion of a sector and prospects for an individual company. All are important, as they in one way or another affect a companys earnings potential. than you lose. By contrast, investing is more Earnings growth is a key signal that the than simply hoping that lucks on your side. market watches to determine whether it Thats because share prices are not random wants to buy or sell any particular share. In outcomes but rather reflect all information general terms, share prices rise where that investors have about a company and its investors anticipate earnings will increase in earnings prospects. future and fall when shareholders expect a Richard Seddon, head of Online Share decline. Trading, says that the economic forces of Under normal circumstances the market supply and demand are the most important anticipates earnings about 18 months in drivers of a share price. Like any other goods advance. Consequently, its important for or services, prices for shares are set at the investors to remember to try and project the future and not make investment decisions based on a recent set of financial results, which show whats happened in the past. Clearly, the overall state of the economy will, at least partly, determine a companys growth prospects. South African investors must remember that its not only the state of the domestic economy that matters but that the international situation is also important. The current situation where concerns about emerging markets in general led to a markdown of SA share prices is a case in point. Investors should also develop a view of an entire sectors prospects, as the market tends to tar companies operating in the same industry with the same brush. A well-run company in a sector with a dismal outlook is unlikely to outperform the market as a whole. By contrast, its not unusual for less admired companies in growth sectors to see their share prices run ahead, at least in the short term. Over the long term each individual companys share price is set by its own performance and the markets assessment of its management. Brown says that quality is allimportant for investors and that will determine whether a companys share price outperforms the market as a whole over time. Quality companies always rise to the top. Ideally, people want to invest in good companies that are doing something well. In addition its useful if they can grow earnings without making acquisitions.

What are shares?

Prudence requires that companies be capitalised with a mixture of debt and equity
AT SOME POINT every company needs to
raise money to expand or grow its business. At that point it has two options: debt or equity finance. In debt financing the company will borrow the necessary capital from either a bank or debt investors by issuing a bond. The alternative is to sell a part of the company in a process known as issuing shares or equity financing. That means shareholders are actually the owners of a company. Each
2 FINWEEK 6 JULY 2006

share represents a tiny claim on a companys assets and earnings. As a shareholder buys more shares, the percentage of the company that they own increases. Both debt and equity have a number of advantages. The big advantage in issuing shares (or equity) is that the companys not required to either pay back the capital amount or make interest payments. Instead shareholders may

receive dividends and invest in the hope of making future capital gains. The first sale of shares by a public company and its listing on a stock exchange is called an initial public offering (IPO). The downside of equity finance, compared to debt, is that debt is cheaper than equity as it doesnt have to compensate shareholders for their higher risk. That has to 4 be balanced against cash flow constraints,

INVESTMENT IN SHARES
2

There are three key terms that investors need to know when looking at ordinary shares. First, authorised shares: the total number of ordinary shares that can be issued. Management can ask shareholders to increase the authorised share capital at the companys annual general meeting. The second concept is issued shares shares that the company has issued and less than or equal to the number of authorised shares. Third, investors speak of outstanding shares: the issued shares that are available in the market place. Companies can also issue preference shares. They differ from ordinary shares in that they have preference over ordinary shares for dividend payments and for assets if the company is liquidated. But the downside is that preference shareholders give up the gains that ordinary shareholders make if the company performs well, as their dividend payment is usually fixed. In addition, preference shares dont have voting rights.

and prudence requires that companies be

capitalised with a mixture of debt and equity. A company can choose to issue two classes of shares: ordinary shares and preference shares. Ordinary shares make up the majority of listed shares and are issued by companies to raise capital. These shares represent ownership by the shareholders of the company and each shareholder is usually given one vote per share to elect board members. The boards job is to manage the managers of the business.

Taking stock of exchanges

A super market
A stock exchange is nothing more than a super sophisticated farmers market. Simon Pateman Brown, MD of SAWarrants

A STOCK EXCHANGE IS nothing more

than a super sophisticated farmers market linking buyers and sellers, says Simon Pateman Brown, MD of SAWarrants. The difference, of course, is that this market buys and sells shares instead of fresh produce. Many countries have these markets. Some of the best known are the New York Stock Exchange (NYSE) and Nasdaq, the London Stock Exchange (LSE) and the
>

Tokyo Stock Exchange. In South Africa, the JSE and its subsidiary AltX are the only markets on which public companies can list their shares. Share exchanges operate under strict regulations. Some exchanges, such as the NYSE, have a physical location where transactions take place on a trading floor. Others like the JSE use a network of computers that trade electronically. A stock exchange has two key purposes. First, its a place where companies can raise capital to finance expansion. Unlisted companies can sell shares to the public through an initial public offering (IPO) and then list on the stock exchange. Companies that are already listed can sell more shares to the public through a rights issue. Second, its a place where buyers and sellers meet to exchange shares for cash. The performance of share or equity markets is tracked by share indices. An

index is basically defined as a statistical measure of the changes in a portfolio of shares representing a portion of the overall market. That means that when an index is up on balance most share prices have increased. Most indices weight companies based on market capitalisation (the share price multiplied by the number of shares in issue). That means price movements of the indexs largest capitalisation companies will have a much larger effect on the overall change in the index than a similar increase or decrease in a small capitalisation stock. The JSEs indices all work on that basis. The JSE/FTSE all-share index is SAs main equity index and is made up of just 160 shares representing more than 80% of the exchanges total market capitalisation. The JSE/FTSE actuaries all-share 40 top companies (Alsi 40 index) contains the JSEs largest 40 shares on the JSE by market cap. The JSE also provides a number of indices that track performance of the different sectors, including the JSE/FTSE allgold index, the JSE/FTSE financial index and the JSE/FTSE industrial index.

QUIZ
has correctly answered each weeks questions. To participate in the draw just answer the following three questions and submit your answers either online to [email protected] or by fax (011) 884-0851.

EACH WEEK WELL PUBLISH

three questions related to that weeks content. At the end of the 12 weeks Online Share Trading will give R10 000,00 worth of Satrix shares in an online account to the reader who

Questions:
1. Which asset class has historically outperformed all others over time? 2. What tracks the performance of shares over time? 3. What is investing not?

Online Share Trading is transacted through Andisa Securities (Pty) Ltd. Reg. No. 1972/008305/07. A registered stock broker on the JSE Limited.
COPY: Kirsty Laschinger 4 FINWEEK 6 JULY 2006 ADVERTISING: Shaun Besarab