Investing

How do you take advantage of the sharemarket’s great upside – higher long-term returns than other asset classes – and reduce the risks?

The first step is education. Yes, it sounds like a cliche that “education is the best investment”, but it truly does make the difference between building long-term wealth and taking dumb risks.

Seek out good information

Getting reliable, independent sharemarket education is harder than it seems, however. Many service providers use sharemarket education as a marketing tool to sell something else. Or education is pitched at more active, experienced investors who create more commission income. Much education is only about part of the puzzle; not enough of it considers share investing in the context of a broader investment plan.

No doubt you’ve heard terms such as “bulls and bears”, “the All Ordinaries Index” and “blue-chip shares”. To make sense of these terms, you need to know why people buy shares, what they get in return and how the sharemarket works. You need to understand the basic ecosystem.

Widen your focus

The most important reason to buy shares is diversification. Sound asset allocation involves having some exposure to the broad asset classes of shares, property, fixed interest and cash. The mix of assets changes depending on your investment goals and time frame, but the logic is the same: holding different types of assets improves diversification and reduces risks. Holding only investment property exposes your portfolio to the risk of a property downturn, just as holding too much fixed interest and cash can be a problem if rising inflation erodes real returns.

The second reason to buy shares is that they provide higher returns than other asset classes over long periods. Australian shares (including dividends) returned an average 11 per cent a year (before tax and after costs) over the 20 years to December 30, 2010, the Russell Investments and ASX-published Long-Term Investing Report shows — slightly more than residential investment property. But with that came painful bouts of volatility, including the dotcom and GFC crashes in the past decade. Think of volatility as the price investors pay for the typically higher returns shares give over the decades and as something to consider in long-term investment plans.

A nice little earner

The third reason to buy shares is for the dividend income paid when companies distribute some of their net profit to shareholders. Some stocks might provide a dividend yield that’s similar to the interest on bank deposits, in addition to capital growth if the share price rises.

The dividend might be worth more than the cash payment if the company distributes franking credits, which reduce the amount of tax payable on the dividend. Australian shares generally enjoy good tax benefits compared with many other investments.

Appetite for expansion

Buying a share gives you part ownership of a company. Let’s pretend you and I start a fast-food chain call Fat Boys Fried Food Australia. We register a private company and use our savings to fund the venture. Sales of deep-fried pizzas are brisk, so we borrow money from the bank (debt capital) to open a second store, then use cash from our two stores to start a third. We realise Fat Boys is a winner and want to turn three stores into 30 before our competition, Heart Stoppers USA, copies us.

The bank won’t lend more money because we’re still too small and risky. So we issue new shares in the company to friends, family and some wealthy private investors, in return for equity capital.

Now we have 30 stores and want 300. We list Fat Boys on the stockmarket through an initial public offering (IPO), or “float”. We believe Fat Boys is worth $10 million, so at listing there are 10 million $1 shares. Those shares go up or down as Fat Boys becomes more, or less, valuable, and as buyers and sellers interact via the Australian Securities Exchange to set a share price.

At this stage, Fat Boys is too risky for big super funds to invest in and too small for sharebroking firms to research. All profits Fat Boys earns are reinvested to expand the business; no dividend is paid.

Within five years, Fat Boys increases annual profit from $1 million to $5 million. The company, worth $10 million at listing, is now worth $50 million and its $1 shares have risen to $5.

Now Fat Boys wants to buy a second business. It sells more shares to fund managers and other investors to raise equity capital.

A few years later, Fat Boys changes its name to FB Consolidated Restaurant Holdings Australia and is worth $500 million. It issues further shares to raise more capital to buy three other businesses and it pays a maiden dividend.

The plan works and FB Consolidated eventually grows to be worth $2 billion, has a lot more shares on issue, pays a bigger dividend, has many stockbroking firms researching it and several fund managers investing in it.

Risk pays off

Over many years, Fat Boys has grown from unknown speculative company to a top-200 stock. Those who invested early in Fat Boys took big risks and enjoyed big returns. Those who bought shares when the company was much more established took less risk but were unlikely to enjoy similar gains.

This trade-off between risk and return is a fundamental investment concept.

Not every company follows this growth journey. Some, like our other hypothetical example, Temple of Boom, struggle for years or collapse.

Fat Boys’ example shows the sharemarket’s true purpose: to help companies raise equity capital by issuing shares. Its shares went up because the company became more valuable. There were more shares in a much bigger pie.

Both examples sound extreme, except that the majority of companies listed on the ASX, by volume, are micro-cap or small-cap companies with higher risk. There were 2247 listed companies, worth $1.35 trillion, at July 2011. The 50 largest companies were worth 63 per cent of the entire sharemarket, by value. Almost half of all the companies listed were involved in the mining or energy sectors or provided related services.

The big fish and smaller fry

To make sense of the sharemarket, you can break it into parts. The first is the top 200 companies by size. This is where you find Australia’s larger, more established, household-name companies. Their stocks are more liquid (they trade more each day), more of them pay dividends and there’s generally less risk than with smaller companies, although that’s hardly the case for all blue chips. It’s here where most super funds, sharebroking firms, financial planners and the media focus.

The next part is the second-line stocks ranked 200 to 300 (or perhaps a touch lower depending on your definition). Fewer fund managers invest in this part of the market and there’s less research.

The final part is made up of stocks outside the top 300, many of which pay no dividends and are too risky for conservative investors. There are businesses such as mining explorers, biotechnology developers and clean-technology companies and many of these stocks are yet to make money or prove their concept.

New sharemarket investors should stick to top-200 stocks and preferably the top 100. More experienced, active investors might have a mix of blue-chip and second-line stocks. Speculators might venture well outside the top 300. There are plenty of conservative, well-run, profitable companies outside the top 300, however, just as there are some risky companies in the top­ 200.

Here’s a useful rule to consider: start with the biggest and best companies when you begin share investing and work your way down as you become more experienced – but only if it suits your goals.