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Share Market Investments

HOW DOES THE STOCK MARKET WORK

The stock market serves two main functions. The primary market function of the ASX is to facilitate a company's raising of funds by issuing securities (shares) to investors. If a company wishes to set up a new business or expand its current business, it can raise money by issuing securities to investors. The secondary market function is where investors buy and sell shares on the stock market.

What are the All Ordinaries and ASX 200 indices?

Stock market indices are used to measure the movement of a certain chunk of the market. This enables one to get a broad idea of how the market is performing on the whole. Standard & Poor's, an international credit ratings agency, calculates various indices on the ASX.

The All Ordinaries Index is for many the predominant measure of the overall performance of the Australian stock market at any given point in time. It is calculated using the share prices of the 500 largest companies listed on the ASX, with capitalisation being the only eligibility criterion. The only exception is that foreign domiciled companies are omitted from the index regardless of capitalisation, meaning that News Corporation is no longer part of the All Ordinaries index since Rupert Murdoch moved its domicile to the US. Being a capitalisation-weighted index (capitalisation is the market value of a company), this means that larger companies have proportionately more effect on the All Ordinaries than smaller companies.

The All Ordinaries can move quite dramatically in one day. For example, BHP Billiton, due to its enormous capitalisation, forms a large percentage of the All Ordinaries. Therefore, if BHP Billiton has a strong day, this will dramatically influence the All Ordinaries in a positive way.

The All Ordinaries was established by the ASX at 500 points in January 1980. On 3 April 2000, the All Ordinaries Index was extended from 300 to 500 companies. It is still the ASX's 'headline' index, acting as an umbrella index, with six ASX benchmarking indices beneath it. These are the ASX 300, the ASX 200, the ASX 100, the ASX 50, the ASX 20 and the ASX Small Ordinaries.

The ASX 200 is worth a mention as probably the most recognised barometer of the health of the Australian stock exchange by professional investors. It is the benchmark against which many fund managers rate their performance. This index includes the top 200 stocks by market capitalisation; however, liquidity is also taken into consideration by the S&P Australian Index Committee.

WHY INVEST IN SHARES?

Flexibility and liquidity

Beyond shares being the best long-term investment and having tax benefits, they also offer other advantages, including flexibility and liquidity.

At any given time, there are usually buyers and sellers in the market for most major companies. As a result, you can buy and sell at your convenience. This aspect of shares, known as liquidity, is in stark contrast to property, which can be expensive and time-consuming to buy and sell. Whilst shares can be sold with one quick phone call or one quick click on the Internet, property can take months to sell. And whilst the proceeds from a sale of shares take 3 days to settle, the standard settlement period for residential property is 6 weeks.

Cost

Another benefit to take note of is that the cost of buying and selling shares is very cheap in comparison to an asset class such a property, and the advent of Internet trading has seen transaction costs drop even further. These days, some online brokers charge as little as $25 to buy or sell. This compares favourably to the stamp duty incurred on property purchases and the agent's fees, marketing and legal costs etc incurred on the sale of property.

Low capital requirements

Another advantage is that the minimum amount of shares that must be purchased when establishing a new shareholding in a listed company is $500 worth. When you are adding to an existing holding, you can spend as little as you want. Therefore, capital requirements are low.

Simplicity

Yet another advantage is that information on your investment is easy to obtain. You can track share prices in the newspapers and on the Internet. Public companies are also required by law to produce an annual report (which is sent to shareholders), disclosing their financial track records for the previous year.

BUYING FOR DIVIDENDS

Whilst a capital gain is an obvious reward sought by investors, many investors do buy shares for the income derived from the dividends that companies pay.

'Ex dividend' means the shares are trading without the dividend and if you buy the shares, you are not entitled to the dividend. Any seller of the shares on or after the ex dividend date is entitled to the dividend (assuming they were holding shares before the ex dividend date).

The price of the shares will drop on the ex dividend date, approximately by the amount of the dividend, to reflect the loss in value from the dividend payout.

Another term that you may hear is the 'record date' (or book closing date). This date is a few business days after the ex date, and accounts for the fact that it takes a few days to settle a trade.

Investors often wonder, if the ex date is 10 June, and they buy on 9 June, will they get the dividend? Yes, they will: the record date is the date that accounts for the three-day settlement, which is the time it takes for you to 'officially' own the shares. Therefore, the record date is the point of reference for ascertaining eligibility for the dividend.

Despite many shareholders being confounded by it, and mistaking it for the ex date, the record date is of no real significance to shareholders. The record date is only relevant to brokers, providing them with a timeframe within which to complete all paperwork pertaining to the dividend. They must notify the share registry as to who owned what shares at which date. Shareholders should simply focus on owning the shares on the ex date if they want the dividend.

The 'payment date' is typically three or so weeks after the record date and as the name suggests, this is the date on which shareholders get paid their dividend.

Dividend Reinvestment Plan (DRP)

Many companies offer a Dividend Reinvestment Plan, which enables shareholders to elect to receive all or part of their dividends in company shares rather than cash. Shares issued this way are usually issued at a discount to the share price, and the transaction costs are paid by the company.

The main advantage of a DRP to a shareholder is that it is an inexpensive and easy way to accumulate/increase a share position.

For the company, it is effectively a sale of new shares and the conservation of cash, as opposed to paying the dividend out in cash. Many people wonder whether they should participate in dividend reinvestment plans or not. The answer to this is simple; if you want to own more shares in the company, it is a good buy of acquiring those shares, and if you don't want to own more shares in the company, then clearly it is not worth participating.

WARREN BUFFETT

Far and away the most famous and successful stock market investor of all time, Warren Buffett has amassed a fortune of more than US$50 billion in a career spanning more than half a century. From an early age, Buffett demonstrated his liking for the stock market, buying his first parcel of shares at the age of 11. From here, Buffett established his entrepreneurial traits, setting up several businesses before he had finished high school. The first was the purchase of a pinball machine which he installed in a barber shop, netting him US$1200. He took this money and bought himself some farm land, which he rented out to tenant farmers. And all this before graduating from high school!

Buffett's interest in the stock market was further enhanced after reading Benjamin Graham's book "The Intelligent Investor", which lead to Buffett applying to Columbia University, where Graham was a teacher. There Buffett obtained his Master's degree in economics in 1951 and, in the process, formed many of his investment philosophies which he would use throughout his life. From here, Buffett worked for a short time in a large investment firm, before returning to his home town of Omaha and setting up the first of what were to be many investment partnerships. Over the next 14 years, Buffett achieved more than a 30% compounded return, at a time when the Index was averaging 10%. It was during this time that Buffett started purchasing shares in textiles company Berkshire Hathaway, which he ended up taking over in 1969. This was to become his major investment vehicle, dissolving all other partnerships. It was here where he met lifetime friend and business partner, Charlie Munger.

Buffett used Berkshire Hathaway's excess cash to purchase private companies as well as shares in public companies. His early focus was on insurance businesses due to the large cash balances they were required to hold in order to pay out claims. Buffett then began to adapt his investment approach, which up until then was based purely on what he had learned from Benjamin Graham. Thanks largely to the influence of Charlie Munger, Buffett was able to further diversify his investment strategy. Together they invested based on fundamentals, placing large importance on earnings growth and competitive advantage, as well as looking for a high return on invested capital.

Buffett's humble and kind nature makes him one of the most popular figures in the US. This is evident by the number of people that flock to Omaha each year to hear him speak at the annual general meeting of Berkshire Hathaway. Last year, there were in excess of 50,000 attendees. He still resides in the house he bought in 1958 for US$31,500 and has donated over US$30 billion dollars to charity, by far the largest single contribution in history. And as the head of a multi-billion dollar corporation, Buffett takes home an honest annual salary of $100,000.