Beginner’s Guide To Equities

Foreword from ShareInvestor

This article “Beginner’s Guide To Equities” by Mindy Tan was first published in The┬áBusiness Times on 25 Apr 2011 and is reproduced in this blog in its entirety.

Knowing the basics of equities is essential to finding order amid the market madness, reports MINDY TAN

“A blindfolded monkey throwing darts at a newspaper’s financial pages could select a portfolio that would do just as well as one carefully selected by the experts,” economist and writer Burton Malkiel famously wrote in his book, A Random Walk Down Wall Street.

Published in 1973, the book talks about the “random walk hypothesis”, which argues that security prices are completely unpredictable, and that one cannot consistently outperform the market.

Before you throw your hands in the air and write off equities, take heart. The legendary investor Warren Buffett is a shining example that there is order amid the madness.

Before we talk about strategies and developing the Midas touch, let us start with the basics.

Defining Equity

Equities, otherwise commonly known as shares or stocks, represent shares in the ownership of a company.

As one of the many owners of a company, you have a claim, albeit a very small one, to everything the company owns. You are a shareholder and thus entitled to your share of the company’s earnings as well as any voting rights attached to the stock.

Broadly speaking, there are two main ways you can profit from your stock: dividends and capital gain.

Company profits are sometimes paid out in the form of dividends. The more shares you own, the larger the portion of the profits you get.

“Dividends can only be paid out of past and present profits. One should look at past financial statements to see if there are records that dividends have been paid in the past. Typically, companies who have paid dividends before will continue to do so,” says Sundaram Janakiramanan, SIM University’s head of programme for finance.

He adds: “Shareholders do not like it when the dividend payments they receive go down. So, a company in an industry where earnings are volatile may choose to pay low or no dividends, in order to maintain the shareholders.”

Capital gain, on the other hand, is profit that results from an increase in the value of the investment. A share’s price may rise, for instance, when a company grows and its value increases.

National University of Singapore senior lecturer of finance Ravi Jain recommends a balanced portfolio.

“In general, all investors regardless of age should own a diversified portfolio that includes high dividend paying stocks as well as high growth stocks (that offer the potential for larger capital gains). For broader diversification, investors shouldn’t limit themselves to equities but also invest in other asset classes such as bonds, real estate, precious metals and commodities.”

Different Types Of Shares

Ordinary shares/common stock

The majority of shares issued are in this form, and share the characteristics including voting rights, claim to the company and so on.

Preference shares/preferred stock

In a nutshell, holders of preference shares are entitled to get preference over ordinary shareholders when it comes to the payment of dividends and/or the proceeds from sale or liquidation.

Dividend rates can be fixed or adjustable based on factors stipulated at the point of issuance. The price you pay for your preference share will also affect the yield you earn from them.

Finally, note that preference shares carry no voting rights.

Convertible preferred shares

Convertible preferred shares incorporate the best of both ordinary and preference shares in that they are preferred stocks that include an option to convert the preferred shares into a fixed number of common shares, usually after a pre-determined date.

The dividend component thus offers a steady income stream and some protection on the investors’ capital. And, the option to convert these securities into stock gives the investor the opportunity to gain from a rise in share price.

In cases of convertible preferred shares, it is important to determine the profit in converting. The conversion ratio represents the number of common shares shareholders may receive for every convertible preferred share. The conversion ratio is typically set by the management prior to issue, typically with guidance from an investment bank.

Putting It All Together

These categories are not mutually exclusive. Singapore water treatment firm Hyflux, for instance, recently put up Class A preference shares at $100 each. These stocks carry a dividend rate of 6 per cent per annum, and are cumulative, non-convertible and non-voting.

“Hyflux’s preference shares are priced at $100 and pay dividends of 6 per cent per year. The payments are made semi-annually so investors will receive $3 on April 25 and Oct 25 every year,” said Prof Jain.

“The preference shares are cumulative so that if, for some reason, the company is not able to make a particular dividend payment of $3 then it would pay $6 on the next dividend payment date.”

He adds: “Unlike common shareholders, the holders of preference shares do not have any voting rights in general. However, the preference shareholders will be given voting rights in some exceptional circumstances, for instance if the company fails to pay dividends on its preference shares for 12 consecutive months.”

Prof Jain also pointed out an additional feature of Hyflux shares: “Hyflux preference shares are callable in 2018. This means that the company has the right to redeem or buy back its preferred shares from investors in 2018. If the company chooses not to buy back its shares in 2018, it will then be obliged to pay dividends at a higher rate of 8 per cent subsequently.”

With this basic grasp of shares, we will look next week at how you can open a trading account and start buying and selling shares.