Education Module 1 The stock market

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1 PO Box 1524 Double Bay NSW 1360 Website Phone / Fax info@rivkin.com.au Education Module 1 The stock market Shares and the stock market WHAT ARE SHARES? Shares are essentially units of ownership in any given company. When you buy shares in a company, you are buying a part of the company. For example, if you believe that BHP Billiton has strong growth prospects, you may decide to buy shares in the company. Being a public company (not privately owned), you are able to buy some equity (ownership) in the company. So you buy shares, and you now own a part of BHP Billiton, and will therefore prosper if the company prospers and its share price rises. Shareholders in profitable companies generally receive a share of the profits in the form of dividends (more on this later). WHAT IS THE STOCK MARKET? The stock market in Australia is operated on a national level by the ASX (Australian Securities Exchange). The ASX is the marketplace within which shares in listed companies are bought and sold. Buyers and sellers come together in the stock market in order to facilitate a transaction. The ASX (along with the Australian Securities and Investments Commission (ASIC)) also has a supervisory role, striving to maintain the integrity of the marketplace. It has a surveillance department, which carefully monitors the market, searching for any irregularities and unscrupulous practices. This department also ensures that any dubious practices are dealt with by the appropriate authorities. As a private investor, you can buy shares on the stock market directly through a stockbroker, or indirectly through a managed fund or superannuation. 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. ITS (Integrated Trading System) is the ASX electronic trading system on which the buying and selling of shares takes place. ITS matches all buying and selling orders by price; when they are matched, a trade results. If two buy orders are at the same price, they are further sorted by the order in which they were entered into the system. Once a transaction takes place, money and shares are exchanged accordingly, so that settlement takes place three days after the trade (known as T+3). 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. Rivkin Securities charges as little as $19.95 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. PO Box 1524 Double Bay NSW 1360 Website Phone / Fax info@rivkin.com.au 1

2 Education Module 1 The stock market CHOOSING A STOCKBROKER Once you are ready to trade, you will need to find someone to buy and sell securities for you. Only stockbrokers are licensed to buy and sell shares for the public and, therefore, it is essential you find, and set up an account with, a broker, before you think about trading. Choosing a stockbroker is a source of confusion for those new to the market. Deciding which broker to choose will depend largely on what products you want to trade and whether you require advice or not. Your profile as an investor is an important thing to consider. Once you have determined what you want out of your investment, you can make various decisions based on this personal profile. For example, is cost your main concern, or is getting advice and access to research the most important function of a broker for you? Stockbrokers tend to fall into one of two categories: advisory (full-service) and non-advisory (execution only). Within the non-advisory category, one has the option of trading over the phone or online. It is important to weigh up their fees and charges and the services and benefits each offers, before deciding which one to go with. Non-advisory broker (execution only) The first category is the non-advisory broker. Since the advent of the Internet and independent advisory services such as The Rivkin Report, as well as large public share issues like AMP and Telstra, advice and general standards of education regarding direct share ownership have lifted significantly. Non-advisory brokers are great for those who know what they want to buy or sell and merely need a broker to facilitate the transactions. Most non-advisory brokers offer an online service in addition to the traditional phone service, and Internet broking fees are without a doubt the cheapest. To read more about non-advisory products and services, please visit Advisory broker (full-service) The second category is the advisory, or full-service, broker. They advise you as to what shares they think you should buy, give you access to their research reports, manage your portfolio and sometimes they will offer you shares in a float (shares that may be difficult to get otherwise). For example, ABN AMRO Morgans, the advisory broker, was the underwriter (which means they arranged the sale of an issue of shares) of Babcock & Brown Power (BBP). The general public found it very difficult to gets shares in this float, but ABN AMRO Morgans clients were offered shares at $2.50. On the day the stock floated (that is, the day that the shares were listed on the stock market), it traded as high as $2.70. So being offered shares in floats can be an advantage. The downside is that the fees are higher than for nonadvisory brokers, as you are paying for the advice as well as the other services they offer. Another drawback is that an advisory broker usually works on commission and hence will pay more attention to clients with a larger portfolio, since they are the major source of income for the broker. So, if you have only a small amount to invest, this type of broker may not be appropriate for you. Furthermore, as brokerage fees are usually negotiable with advisory brokers, you are more likely to be able to negotiate a better rate when your trades are of a greater size and frequency, and so you are somewhat disadvantaged if you aren t trading with a lot of money or frequently. The relationship you have with your advisory broker is a unique one, in that it must be nurtured in order to achieve the best results. A successful advisory broker/client relationship requires time and good communication. Both parties must know each other well for the relationship to work effectively. Conclusion Once you decide what kind of broker you are after, finding one is easy. Obviously, we would recommend Rivkin Securities on 1300 RIVKIN if you are after a non-advisory broker; however, to shop around, simply visit the ASX website at Buying and selling shares OPENING AN ACCOUNT Opening an account with a stockbroker is a bit like opening a bank account. You can commence the process by phoning them, filling in various forms online or going into their offices, but ultimately you will have to sign the forms and provide certified photo identification before the account setup is complete. If trading online, the broker will require you to open a money market account or cash management trust account, into which you can deposit funds that will be used for trading. This is like any normal interest-bearing account. When you make a purchase, the broker will automatically withdraw the correct amount of funds from the account and when you sell, the proceeds will automatically be credited to your account. The same process occurs for phone trading. 2 PO Box 1524 Double Bay NSW 1360 Website Phone / Fax info@rivkin.com.au

3 The stock market Module 1 Education CHESS Traditionally, when you bought shares through your broker, you were issued with a share certificate (known as scrip), which was evidence of your ownership in the company. These days, however, this can all be taken care of by CHESS (Clearing House Electronic Subregister System), which is a development in which shareholders in listed companies receive statements, much like bank statements, advising them of their holdings. Because this system is electronic, ownership of shares can be transferred without having to rely on paper documents. All share transactions are made easy with CHESS. Prior to CHESS, your broker couldn t sell your shares until you sent them the share certificate. Now, they will ask you to sign a CHESS sponsorship, which means they can buy and sell shares a lot more easily on your behalf. Another important benefit is the ease with which you can accept a takeover bid for shares you own in a target company. Rather than filling out a myriad of forms, you can simply phone your broker and ask them to accept the bid on your behalf. They will require a signed authorisation, but the process is made very easy with CHESS. A holding statement is issued to you whenever the amount of shares you own is changed by either a sale or a purchase of shares. HIN You also have a HIN (Holder Identification Number). This HIN will be the same number as for CHESS-sponsored holdings, no matter what the shares. If, however, your holdings are issuer-sponsored (individual companies send you a share statement as evidence of your ownership), then you will receive a different HIN for the holding you have in each different company. When CHESS sponsored, you may need to quote your HIN when you place an order to buy or sell. The CHESS system speeds up settlement (the payment or receipt of funds after a buy or sell) and transfer of all transactions. BUYING SHARES Now that you have signed up with a broker, you are ready to start buying shares. At this stage, all you have to do is contact your broker and ask to buy x shares in x company at x price. It s as simple as that. You will have to check with your broker to see what price the shares are trading at. If a company is trading at $1 per share, there is not much point in trying to buy on that day at 50c. The broker then executes the order on your behalf by entering it into their computer system, and transmitting it to the ASX. CHESS transfers the shares electronically and notifies the company s share registry of the transaction and of your details. You will receive confirmation of the order via a contract note, which is sent to you via or post by your broker. SELLING SHARES When the time comes to sell your shares, you will need to contact your broker. The process is the same as buying shares, except you instruct your broker to sell x shares in x company at x price. Your broker will inform you of the price of the share, so that you can set the limit. Again, make sure you set a limit when selling online. CHESS will transfer the shares and will notify the company share registry of the transaction and the new shareholder s details, the person who bought what you sold. In three to four business days, you will receive proceeds from the sale, less brokerage and GST. BROKERS COSTS Brokers usually charge a flat rate up to a certain amount, and then fees are charged on a sliding scale according to the value of the transaction. Below are two tables showing the approximate costs of an average advisory and nonadvisory broker. Non-advisory broker Internet: $19.95 up to $10,000 transaction value $29.95 up to $30, % above $30,000 Phone: $59.95 up to $30,000 transaction value $89.95 up to $80, % above $80,000 *These brokerage rates are based on Rivkin Securities brokerage costs as at September Advisory broker Amount traded Costs $0-$50, % with a minimum of $90 $50,000-$100, % $10,000+ 1% *These brokerage rates are a sample indication of advisory brokerage costs, based on Bell Potter s FSG as at September They are only indicative and are usually negotiable. As you can see, the associated costs are very different depending on what type of broker executes the transaction. As expected, the advisory broker would PO Box 1524 Double Bay NSW 1360 Website Phone / Fax info@rivkin.com.au 3

4 Education Module 1 The stock market charge the most at roughly $90 minimum, whereas the minimum with a non-advisory broker is more likely to be around $20. SETTLEMENT AND TRANSFER When you buy shares, on the other side of the transaction there is a seller. For every buy, there is a sell. The money you owe for the shares is owed to the seller and must be exchanged for the seller s ownership in the company. This process is called settlement and transfer. The contract note, that you are sent serves a greater purpose than just confirming your order. This contract note itemises the cost of the shares, including the brokerage and GST. For buy confirmations, you need to pay the amount shown within three business days of the transaction date. For sell confirmations, you will receive the proceeds three business days after the sale. This is known as T+3, which is the transaction date plus three days. On the contract note, this date is often referred to as the settlement date. One important point to mention here is that you can t pay your broker via credit card. Brokers offer several payment options, but credit card is not one of them. COMPANY CORRESPONDENCE When you buy shares in a company for the first time (i.e. you are not already a shareholder at that point in time, even though you may have owned shares in the past) and your name goes to their share registry, you are, as a new shareholder, automatically sent some documents that require your attention. There are generally three documents sent to you. Firstly, you will receive a tax file number notification form, asking you to fill out your individual or company tax file number (or exemption). You must fill out this form if you don t want the company to deduct withholding tax from your dividend payments. Withholding tax is the tax levied on dividends and interest payments made to nonresidents. Filling out this form will ensure you receive the full amount of the dividend, with the usual tax implications being addressed at the conclusion of the financial year. The next form you will probably encounter (depending on whether the company offers one) is a dividend reinvestment plan application form. Many companies offer dividend reinvestment plans (DRP), which enable shareholders to elect to receive all or part of their dividends in company shares rather than cash (more on this later). The benefit of this is that shares are usually issued at a discount to the share price, and the company pays transaction costs. Hence, the advantage to participating in a DRP is that it is a simple and inexpensive way of accumulating more shares in a company. If this is of interest to you, then you must fill in the DRP form. If you would rather receive your dividends in cash, then by all means discard this form. This leads us to the third and final form, which is a direct credit form. If you have decided that you are not interested in the DRP, and want to receive your dividends in cash, this form gives you the option of having your dividends directly credited to your nominated bank account by the company. If this is of no interest to you and you are satisfied receiving your dividends in the form of a cheque, then you can discard this form as well. REWARDS OF INVESTING IN SHARES The rewards of investing in shares come in the form of dividends (income) and capital gains. Dividends When a company is profitable, the shareholders have a right to share in a portion of the profits. The payment commonly comes in the form of a cash dividend (scrip dividends do exist). The word dividend means that which is divided. Dividends are a dividing up and distribution of a portion of a company s earnings to shareholders. The board of directors of the company decides how much of the profits will be paid out in dividends. Companies generally pay dividends twice each year; an interim dividend and a final dividend. Dividends are paid either franked or unfranked. A franked dividend is a dividend on which company tax has already been paid by the company and the shareholder receives a tax credit for this amount (see Dividend imputation, below). Dividends can be partially or fully franked. An unfranked dividend means the recipient is subject to tax at their normal marginal rate. Dividend imputation There are franked and unfranked dividends, and a franked dividend is a dividend on which company tax has already been paid. Dividend imputation was introduced in Basically, investors who receive franked dividends are entitled to a credit (known as a dividend imputation credit or franking credit) for the amount of tax already paid by the company. This credit reduces the amount of tax to be paid by the investor. 4 PO Box 1524 Double Bay NSW 1360 Website Phone / Fax info@rivkin.com.au

5 The stock market Module 1 Education In simple terms, the shareholder is allowed to claim the imputation credit as a tax rebate. As an example, let s say that National Australia Bank (NAB) pays a final 80c fully franked dividend. As the corporate rate in Australia is 30%, this means that NAB has already paid 30% tax and the 80c the investor receives is post tax. So how do we work out the pre tax amount? We simply say that if 30% tax has been paid, then 80c is equal to 70%. So what is 80c 70% of? 80 divided by 0.7 equals 114.3c. Therefore, we can work out the amount paid in tax by NAB (or franking credit) by subtracting 80c from 114.3c, which equals 34.3c. So if one owns 1000 NAB shares, this means that the dollar value of the franking credit is 1000 multiplied by 34.3c, which equals $343. This amount can be offset against one s taxable income to effectively reduce tax payable. For more information, talk to an accountant or the Australian Tax Office. 45-day Rule People can get very excited when they first hear about franking credits. They contact us at The Rivkin Report and ask whether they are able to buy one day before the company goes ex dividend (explained later) and then sell on the day the stock goes ex a dividend and still collect the franking credits. The answer is yes but there is a condition. If you have less than $5000 per annum of franking credits, then you can hold the stock for one day if you choose to and still receive the franking credits. However, should you have more than $5000 per annum in franking credits, you must hold the shares for at least 45 days in order to claim the franking credits on dividends received. This means that you can t buy shares the day before a company goes ex and then sell the next day and claim the franking credits on the paid dividend. That would be a little too easy! In summary, if a person claims less than $5000 worth of franking credits in a given year on their tax return, then they do not have to satisfy the 45-day rule. If they wish to claim $5000 or more of franking credits, then they must own all the shares that received dividends for at least 45 days. Dividend rewards Consider the following example of a stock that rewards shareholders with a regular income, in the form of dividends. The following table demonstrates how $1000 invested in the Commonwealth Bank of Australia (CBA) from June 1996 to June 2006 would have performed. TABLE 1 At the end of June Share price Total market value of shares Dividends per share for the year Total value of dividends received 1996 $10.46 $ c $ $15.71 $ c $ $18.66 $ c $ $24.10 $ c $ $27.72 $ c $ $33.50 $ c $ $32.93 $ c $ $29.55 $ c $ $32.66 $ c $ $37.78 $ c $ $44.41 $ c $ Final market value: $ Total value of dividends received: $ In the ten years to June 2006, $1000 invested in CBA would have grown to $4246 plus the $1435 in dividends received. This results in a total return of $5681 (a 468% return on your $1000 over 10 years not bad at all!). Capital gain A capital gain occurs when an investor sells shares at a higher price than the original purchase price of the share. Most people invest for capital growth (i.e. they buy a share in the hope that the price will rise). Capital gains rewards Consider an example of shares that have rewarded investors with growth in the form of capital gains (share price increase). The following table demonstrates how $1000 invested in Woodside Petroleum (WPL) from June 1996 to June 2006 would have performed. TABLE 2 At the end of June Share price Total market value of shares Dividends per share for the year Total value of dividends received 1996 $7.64 $ c $ $11.44 $ c $ $8.12 $ c $ $10.23 $ c $ $13.01 $ c $ $15.99 $ c $ $13.57 $ c $ $12.38 $ c $ $16.70 $ c $ $29.25 $ c $ $44.00 $ c $ Final market value: $ Total value of dividends received: $ PO Box 1524 Double Bay NSW 1360 Website Phone / Fax info@rivkin.com.au 5

6 Education Module 1 The stock market In the ten years to June 2006, $1000 invested in WPL would have grown to $5759 plus the $ in dividends received. This results in a total return of $ (a 543% return on your $1000 over 10 years!). 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. There are several terms that you will hear when it comes to dividends, and it is important that you understand the terminology involved. Once a company has declared an upcoming dividend, its shares will trade cum dividend for a while. This means that the shares are trading with the dividend and if you buy the shares, you are entitled to the dividend. Ex dividend simply means that the shares are trading without the dividend and so 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 the 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. For example, if a company is trading at 50c, and is cum a 4c dividend, with an ex date of 10 September, it is obvious why, after the ex date, the shares are trading without the dividend. If you buy on 9 September at 50c, then on 10 September, the shares will be trading at around 46c, so all buyers (on or after the ex date) go without the dividend and all sellers at 46c get the 4c dividend (if they bought cum dividend). The logic behind the drop in price is fairly obvious, but it should be explained, because many first-time investors believe that dividends offer a potential get-rich-quick scheme. Going with the above example, if you bought shares on 9 September at 50c and the shares were going ex the next day, you wouldn t be able to sell at 50c the next day and get the 4c dividend. Otherwise, investors could go in, buy shares the day before their ex date, receive the dividend and sell at their original price the next day. You could become a millionaire in no time at all by trading ex dividend dates. Obviously, share prices drop to reflect the loss of value from the pay-out of the dividend. However, it is important to note that whilst this drop almost always happens, shares have been known to retain some or all of their value on the ex date. 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 ask me if the ex date is 10 September, and they buy on 9 September, 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 Dividend Reinvestment Plan to a shareholder is that it is an inexpensive and easy way to accumulate/increase a share position. For the company, a Dividend Reinvestment Plan is effectively a sale of new shares and the conservation of cash, as opposed to paying out the dividend in cash. In terms of whether one should particpate in a Dividend Reinvestment Plan, it really is up to the individual. If one wants to own more shares in the company, it is a good way of acquiring those shares, on account of the shares being offered at a discount to the prevailing market price and the fact that brokerage need not be paid on the acquisition of these new shares. However, if one has no desire to own more shares in the company, then clearly there is no point in participating in the Dividend Reinvestment Plan. 6 PO Box 1524 Double Bay NSW 1360 Website Phone / Fax info@rivkin.com.au