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The basics of investing in shares

The basics of investing in shares

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Investing in shares, which are generally referred to as equity securities in the financial world, represent an ownership interest in a public or private corporation. Investors provide capital to companies to finance growth and expansion, and in return become stakeholders in the future cashflows of the business. In return for their investment in the company, shareholders may receive periodic payments called dividends, which are paid from the company’s net profits. 

In contrast to coupon payments on bonds (which are a contractual obligation on the issuer), dividends are largely discretionary in nature.The dividends declared will depend on company profitability, the investment opportunities available to the company (some or all profit may be retained for reinvestment) and the company managements’ policy on paying dividends. 

What are the characteristics of a share? 

  • Price: the current market price of a share is the price at which the share currently trades ie the price investors are willing to pay for the share, or demanding to sell the share. Price movements are driven by various factors including supply and demand and market and economic factors. Over the short term, investor sentiment (fear and greed) can cause big fluctuations in price, that are completely independent of the value of the share. Over the long term, if the earnings (after-tax profits) of a company grow consistently, the share price should follow a similar trend. 
  • Dividend: is a method by which company profits are distributed to shareholders, declared in cents per share. It is a discretionary amount which depends on company profitability and managements dividend policy 
  • Dividend yield: This is the dividend per share divided by the market price per share. It is a simple measure of the return or income generated from owning the share, measured in percentage terms. For example, if the current share price of a company is R25.50, and a dividend of 102 cents per share is declared, the dividend yield will be calcuated as (120c/2550c) = 4%. Companies in the mature life cycle tend to have more stable dividends at a lower yield. 
  • Price/earnings ratio: This is the price of a share divided by its earnings per share (after-tax earnings of the company divided by the number of shares in issue). The P/E ratio is an indication of the how much you are paying for a company’s earning power. All things being equal, a higher P/E is indicative of a share being more expensive and that the market has high earnings expectations from the company going forward. These earnings expectations are not a guarantee however and actual earnings may be higher or lower than what has been forecast by market analysts.
  • The total return on an equity investment will be a function of any dividends declared plus or minus any capital gains or losses as a result of changes in the market price of the share. 
  • Tax implications: Investing in shares (or equities) can be more tax efficient than investing in cash or bonds say, where all income is taxed at an investors marginal tax rate (ie. the tax rate applicable to an individual on every additional rand that they earn). Currently, the dividend tax rate in South Africa is 20%. For example, if a dividend of R25.50 per share is declared by a company, the investor will receive an after-tax dividend of R20.40 for each share owned in the company, and R5.10 per share (the 20% dividend with-holding tax) will be paid to SARS on the investor’s behalf. Upon sale of an equity investment, a capital gain (when a share is sold for more than you paid for it) or capital loss (a share is sold for less than you paid for it) is realised. In the event of a gain, capital gains tax is payable, after allowing for any capital gains tax exemptions, if applicable. Currently (as of the 2022-2023 tax year), the maximum rate of capital gains tax in South Africa is 18%. These exemptions and dividend and capital gains tax rates are determined annually by the South African Revenue Service. 
General classification of shares (equities) 

Equity investments are most commonly classified by: 
  • Size: Equity shares can be broadly categorised as small-cap, mid-cap and large-cap shares depending on the market capitalisation of the company. The market capitalisation is a measure of a company’s value calculated by multiplying the number of shares in issue by the current market price. Large-cap shares in South Africa fall within the JSE Top 40 and are the most liquid ie. can be bought and sold relatively quickly. Small-cap shares are smaller companies with potential for higher returns (and higher losses) and are typically less liquid than large-cap shares. 
  • Sector: Three main categories/sectors constitute the South African equity market: 
    -  Financials – companies in the financial services sector such as banks and life insurers 
    -  Resources – companies in the mining and non-mining resources sectors eg Sasol and Billiton 
    -  Industrials – companies that fall outside the financials and resources sectors such as retail (Woolworths, Truworths), healthcare and consumer goods. 
Why are equity investments useful in an investor’s portfolio? 

  • Over the long-term, equity has delivered the highest returns above inflation of the main asset classes (+/- 7-8% above inflation per annum). 
  • A healthy exposure to equity in your portfolio is critical for long-term wealth creation and maintaining one’s purchasing power over your lifetime. This allocation to equities in your portfolio may vary depending on the particular life stage you are in, timeframe for investment or investment objective. For example, a young person at the beginning of their career may wish to have the maximum allowable allocation to equity as they save for their retirement many years into the future. An older person in retirement, may wish to moderate their allocation to equity investments as they draw-down on their income, but still wish to achieve inflation-beating returns to manage the risk of having to reduce their standard of living in time. 
  • Equity investments are more tax efficient than either cash or bonds as dividends are currently (2022-2023 tax year) taxed at 20% and the maximum effective capital gains tax rate for the current year is 18% for high marginal taxpayers with an income tax rate of 45%. For those with a lower income tax rate, the effective capital gains tax rate will be even lower. 
What are the risks of investing in shares (equities)? 

These are some of the key risks to consider when investing in equities: 
  • Investing in equities should be considered a long-term investment and requires an investment horizon of at least 5-7 years. You should thus not consider investing 100% of your capital in equities if that capital will be needed over the short term (eg. As an emergency fund for unforeseen expenses). Invest with capital that will not be needed over the short term, and where your goals are longer-term in nature eg. Saving for your baby’s education, saving for retirement etc. 
  • Equity markets can experience significant periods of short-term volatility (big up and down movements of prices). Expect and be prepared for this volatiliyt over the short to medium term as the superior long-term returns that this asset class delivers do not come in a straight line There may be years of very large positive returns (eg. 20%, 30% or even 40%), but also years of very large negative returns (-20%, -30% or even -40%!) 
  • It is possible for a company to go into liquidation or bankruptcy in which case equity investors may lose some or even all of their investment in that company 
  • Fear causes investors to sell when they should be buying (prices fall and markets are cheap), and greed to buy when they should be selling (prices rise significantly and markets are considered expensive). These are normal human emotions but need to be managed with care in investing to avoid buying and selling at the wrong time, thus diminishing the long-term total return from your investment. A reputable and qualified financial planner can help you navigate these emotions by helping you to develop a sound financial plan to meet your objectives and stay the course when things get rough. 
How to own shares 

Shares of listed companies are traded on an exchange (in South Africa this is the Johannesburg Stock Exchange) which provides better liquidity than an ownership stake in private or unlisted companies. Investors with the requisite skill and experience can invest directly with the help of a stockbroker, although this can be a costly option both in terms of the direct costs associated with trading, and the time commitment required to manage one’s own portfolio. 

An equity unit trust (or balanced fund with an exposure to equities) managed by a reputable asset manager, helps to reduce some of the individual company risk by spreading your investment across a basket of equities, rather than just a handful. Investing in a unit trust also means that your investment is very accessible if needed, usually within a day. 

This benefit of having a well diversified, professionally managed portfolio of shares within a unit trust does come at a cost though. This is an annual management fee payable to the asset manager usually expressed as an annual percentage (eg. 1.0% per annum, plus VAT), and is payable on the full amount of your investment in the fund. (eg. A fee of 1% on R10,000 invested for one year will result in asset management fees of R100 for that year, all else being equal. Note that this example ignores the fact that while the percentage fee is fixed, the rand amount of the fee will vary as share prices fluctuate). 

To summarise: 

  • Over the long-term, equity investments have provided investors with the highest real returns (returns above inflation) of the asset classes but requires a long-term investment horizon. 
  • A healthy allocation to equity (appropriate to your individual goals, investment timeframe, and life-stage) is vital to growing your long-term wealth and maintaining and/or growing your purchasing power into the future. 
  • However, returns from equity investments can be highly volatile and unpredictable and there is also a risk of losing some or all of one’s capital invested. 
  • Diversifying your portfolio across companies, sectors, regions (ie. outside of South Africa) as well as other asset classes, is one of the most sensible ways to reduce (but not eliminate!) risk.