Direct investment in a company involves holding equity, that is, a direct share in the ownership of the company, available where the company issues shares. There are two basic types of share: ordinary and preference.

Ordinary Shares

The most common stock market investment is to deal in ordinary shares. These are the shares that are usually referred to when discussing the company's share price. Ordinary shares confer upon the holder a share in the ownership of the company with each share entitling the holder to an equal share of the profits and vote at company meetings. Profits will be distributed by way of dividends and are paid net of 10% tax. Unless the stock is held in an ISA, it is not possible to reclaim this tax.

Preference Shares

Preference Shares are considered less risky than ordinary shares because they are higher up the pecking order should the company be liquidated. Similarly their dividend is paid before that of ordinary shares and so is more secure, though not guaranteed.

The dividend is usually cumulative, meaning that if it is not paid in any particular year, the arrears should be paid in future years before the current payment of the ordinary dividend. Dividends are usually fixed at a certain percentage, though where stock is participating, investors are entitled to a share in profits should they reach a certain level. Normally, preference shares carry no voting rights.

Convertible Preference Shares confer upon the holder the right to convert into ordinary stock at specific set dates. This means that income-seeking investors can take advantage of the usually higher dividend with a view to converting in the future, should conditions be appropriate.

See also Zero Dividend Preference Shares.

Deferred Shares

Deferred Shares will carry a deferred right of some kind. Usually, these will take the form of voting rights or a dividend.

Dividends

Dividends are distributions of the company's profits and are usually paid twice yearly: interim and full year. Occasionally payments are more or less frequent. If there are no profits a dividend will not be paid. Investors will be entitled to the dividend so long as they purchased the stock before the ex(excluding) dividend date. The stock is, therefore, purchased cum (including) dividend.

Time line	Ex div date	Payment date

Buyer entitled to dividend

Seller entitled to dividend

Corporate actions

Splits and consolidations

Investors' mentality in the UK and the US can sometimes be different. In the US, there is a propensity for 'big' stocks in terms of pricing. To pay more than $100 for a stock is not uncommon. In the UK, we tend to prefer smaller units for increased liquidity. The pricing does not affect the expensiveness of a stock, see P/E ratio.

Where a company decides its shares are priced too highly, it might adjust the share capital by enacting a stock split. A 2:1 stock split would mean that the investor receives two new shares for each old share he owned. Although the number of shares has increased, the overall value will remain fairly constant as the share price would halve.

Similarly, if a company decides its shares are too low, it might consolidate the share capital by reducing the number of shares in issue. Here the value of investors' holdings would also remain constant as the price per share will have increased.

Rights Issues

As we have seen, firms float themselves on the stockmarket in order to raise finance. Once they are floated they can raise further funds by issuing new shares, rather than taking on debt. However, to do so would dilute existing shareholders' holdings as the price will fall as new shares come into existence. The company must, therefore, offer the new shares to existing shareholders who have a 'right', though not an obligation to purchase them in proportion to their existing holding. The rights issue will usually be discounted to market value, making it an attractive proposition. Investors should expect a bigger discount where the company intends to raise a relatively large sum.

When confronted with a rights issue investors can:

• Take up the rights by purchasing the stock
• Sell the rights, meaning the percentage holding will fall
• Sell partial rights or sufficient to cover the purchase of the remaining rights. This can be calculated by multiplying the number of rights by the rights price and dividing by the ex-rights price.
• Do nothing and allow the issue to lapse. You should receive payment equivalent to their value.

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A bond is a fixed rate security issued as debt and repaid at a future date. Companies and other institutions issue bonds to cover their short-term debt from time to time. Where national expenditure (public spending) exceeds income (from taxes), governments also need to borrow. The cheapest method of doing this is to issue bonds. UK government bonds are known as gilt edged securities or gilts.

Types of Gilt

The gilt market is split into three classifications, according to their redemption date or maturity. The FT classifications are as follows:

• Shorts (less than five years)
• Mediums (five to fifteen years)
• Longs (more than fifteen years)

The Debt Management Office (DMO) classifies gilts as Shorts (up to seven years), Mediums (seven to fifteen years), Longs (more than fifteen years).

These gilts are always repaid at par, or £100. That does not mean gilts can only be traded in sizes of £100, but they are merely quoted in terms of the amount required to obtain £100 nominal of stock. Gilts said to be trading below par would, therefore, be priced at less than £100 nominal; above par, more than £100 nominal.

Investors are prepared to pay over par in return for the income or yield attached to the security. Clearly it is advantageous to pay below par, but this is not always possible. The rate of interest paid on a gilt is known as the coupon and is paid on the nominal amount of stock at a fixed rate.

There are two other types of gilt: undated and index-linked.

Undated gilts

have no redemption date but pay ongoing interest. The government has the option to repay these but their low interest rate makes it unfavourable to do so. Only with the Conversion 3½ % stock is the government obliged to redeem part each year. The most famous undated gilt is the War Loan 3½ %, left over from the First World War. Given the low coupon level, rates would have to fall considerably for the government to decide to repay it.

Index linked gilts

are tied to the rate of inflation. Both redemption and interest rate are linked to the RPI figure eight months hence. They are useful for investors worried that inflation will erode the value of their investment.

See the gilt list for current data on UK government bonds.

Low Risk

No British government has ever failed to repay a gilt which is why, if held to redemption, gilts represent a very low risk investment. Gilts are suitable for those seeking income or as a suitable alternative to cash in a portfolio. It is sensible for any diversified portfolio to have an element of fixed interest securities, to a lesser or greater degree depending on attitude to risk and prevailing market and economic conditions. When considering gilts, you should look at relative attractiveness of alternative products given your objectives.

Gilts and Interest Rates

Gilt prices have a direct correlation with the level of interest rate. As rates rise, gilt prices fall, raising the flat yield and vice versa. This keeps gilts competitive with fixed rate alternatives. The longer dated a gilt, the more its price will tend to fluctuate. Shorter dated securities experience a "pull to redemption", that is investors know they will be repaid at par shortly and so the price will gradually move closer to par.

Yields

The yield of a gilt is important. Our gilt list shows these figures. However, the formulas are reproduced below to demonstrate their respective importance.

Because the price moves with supply and demand, the flat yield will alter. The flat yield can be calculated as follows:

gross coupon price

x 100 = flat yield

Gilts trade at different coupons and prices. In order that investors can compare the relative attractiveness of different gilts, combining coupon and price, the gross redemption yield is used. This is calculated as follows:

[

gross coupon price

+

(par-price)\years to repayment price

]

x 100

Gilts do not attract capital gains tax. However the yield is subject to income tax. Because investors pay tax at different rates, the relative attractiveness will depend on the amount of tax they must pay. A higher rate tax payer, for instance will be more inclined toward return from capital than income. A further calculation determines the net redemption yield:

[

{

gross coupon price

x (1-marginal tax)

}

+

(par-price)\years to repayment price

]

x 100

An important feature of gilts is the accrued interest. The interest or coupon is paid at given intervals to the holder of a gilt. However, where a gilt is purchased cum (including) dividend, the buyer receives the full payment for the period and so must compensate the seller. Where a gilt is bought ex (excluding) dividend, the purchaser will not receive the interest payment. This is all reflected in the price. As a result there are two methods of quoting gilt prices:

Clean Price

(this will not include accrued interest which will be added to the bargain)

Dirty Price

(this is the total price of the gilt calculated by adding or subtracting the interest adjustment from the clean price).

Gilts are a low risk method of achieving income return and diversification in a balanced portfolio as an alternative to cash.

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All collective investments operate in the same way to the extent that they pool cash to invest in a number of stocks. They are useful because they provide diversification in a single investment. If you want to gain exposure to a market such as FTSE 100 or AIM, sectors such as TMT or Pharmaceuticals, specialist areas such as geographical or global sectors, without investing directly you can take advantage of these vehicles.

Unit Trusts

Unit Trusts (UTs) are the most common form of collective investment for the private investor. UTs are characterised by a trust legal structure and trade at Net Asset Value. UTs are 'open ended' meaning that when an investor wishes to buy, units are created. Similarly, units are cancelled when an investor wishes to sell - or in reality buyers and sellers are netted off against one another and the Unit Trust manager charges each. They are priced daily (in the afternoon) and not quoted on an exchange.

Investment Trusts

Investment Trusts (ITs) are not in fact trusts but "Investment Companies". Like UTs they invest in a variety of companies but like any other listed company are quoted on an exchange. ITs are, therefore, 'closed ended' meaning that there are a limited number of shares in existence. They do not trade at Net Asset Value as their price is determined by supply and demand.

Investment Companies can trade at a premium or (more likely) a discount to Net Asset Value. This means that you can pay less than the sum of worth for a collective investment. Unfortunately, it is not possible for a private investor to unlock that worth and so you must wait for discounts to narrow. The tech bubble at the beginning of 2000 led to many technology orientated ITs trading at a premium to NAV meaning investors were paying more for a share than the sum of its parts. This is fairly unusual. When discounts widen considerably, ITs are vulnerable to being wound up by major shareholders (large institutions) to release their value. You should examine closely the discount at which Investment Trusts trade as it is a fundamental indicator of their relative value.

OEICs

Open Ended Investment Companies (OEICs) are hybrids of Unit Trusts and Investment Trusts. Like a Unit Trust, they trade at NAV, are priced daily and are not quoted on any exchange, but like an Investment Trust, they have a company rather than a trust structure. This makes them easier to market across Europe. Other differences include single pricing and an umbrella structure.

ETFs

Exchange Traded Funds (ETFs) were launched in London in April 2000, following their success in the United States. Barclays Global Investors' iShares, were joined by Merill Lynch's LDRS in 2001. Both of these track indices and sectors.

The London Stock Exchange has created a new market, ExtraMARK, for these innovative products. As hybrids, ETFs trade at NAV, but crucially are quoted on an exchange, meaning that an up to date price is always available during market hours. ETFs are more transparent than traditional Unit Trusts meaning that charges are lower.

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A much underused investment product is the Split Capital Investment Trust. These put products with a variety of different objectives within one vehicle. Consider the competing demand of an investor requiring income with one clamouring for growth. A split capital trust offers both. The vehicle is split into two or more classes of share: fundamentally capital and income classes. The equity exposure in the classes of share is identical although methods of return vary considerably. Split capital trusts have a limited life span upon which date the fund will be liquidated.

Splits accommodate differences in objectives and attitudes to risk. When the fund is liquidated, shareholders are ranked in order of priority with preference shares paid first (therefore the least risky), then income and annuity followed by capital shares or highly geared ordinary shares (most risky). The fund's assets must grow at a greater pace to pay those at the bottom of the priority list than those at the top. As always though, with greater risk comes the promise of greater rewards.

Income Shares

Income share investors are entitled to all of the income derived from the fund together with a fixed entitlement to capital, which may only be a nominal amount. Suitable for investors requiring a relatively high income, this class of share receives a very small portion of the proceeds on liquidation

Capital Shares

Capital shareholders are entitled to everything left upon liquidation once other classes of share ahead of it in terms of priority have been paid. More risky, they are also more volatile, paying no income. These are suitable for a pure growth investor who is prepared to accept risk.

Zero Dividend Preference Shares

As the name suggests, zero dividend preference shares pay no income throughout their life but pay a predetermined capital sum upon liquidation (which is also predetermined). Despite some split capital trusts borowing too much and in investing in each other at a time of market weakness, zeros remain the lowest risk share class. Most zeros revel in asset cover high enough to satisfy even the most nervous investor.

They are suitable for long term planning as a number of these products can be bought to pay out at predetermined dates, meeting contingencies such as school fees or home improvement. They are also suitable for those requiring income who do not make use of their capital gains tax allowance.

When zeros pay, they pay as capital, which does not attract income tax. They are dealt on the stock exchange and may be bought and sold at any point during their life. Price is affected by the bond yield and how well covered the assets are. Also, the price will experience a 'pull to redemption' as it approaches its payment date where it will gradually move toward the level of repayment.

Zeros are an underused instrument which can form a fundamental part of investment planning. Zeros can satisfy part of long and medium-term strategies because of their certainty. Because they pay out at set times and set amounts, investors can use them to cover known requirements while making efficient use of their tax allowances.

Stepped Preference Shares

Stepped preference pay a constant dividend over the life of the investment but only a nominal return in terms of capital. These are suitable for the cautious income investor.

Highly Geared Ordinary Shares

Along with capital shares, highly geared shares are entitled to remaining assets although also pay an income during their life. Risky, they are suitable for a more balanced investor who is prepared to take a view on the instrument.

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Covered warrants are 'securitised derivatives' conferring the right but not the obligation to buy or sell assets at a pre-determined price on or before a pre-determined date.

Unlike traditional warrants, issued by companies or investment trusts which confer the right to buy new shares, covered warrants are issued by large financial institutions and confer the right to buy or sell existing shares. 'Covered' relates to the requirement of the issuer to hold (or hedge) a sufficient amount of the underlying asset to cover the issue. However, covered warrants are overwhelmingly cash rather than physically settled so investors need never take delivery of the asset. This means that covered warrants are exempt from stamp duty. Covered warrants automatically exercise at expiry. They are traded on the stock exchange and are CREST settled (T+3).

Special risks apply to dealing in covered warrants. These risks are documented in a formal risk warning. To satisfy the regulations, investors must have read and understood the contents of this warning and will only be permitted to deal in covered warrants once this has been confirmed.

If a warrant expires 'out of the money', that is where the strike price is higher than the price at which the underlying is trading for a call warrant, or lower than the underlying price for a put warrant, the warrant expires worthless. In such circumstances, investors lose their premium or the cost of buying the warrant.

Types

There are two types of covered warrant: Calls and Puts. Calls confer the right to buy an asset; puts the right to sell an asset. Calls are used to profit from a rise in the price of the underlying asset, put investors gain when the underlying falls.

Style

Covered warrants come in two styles: American or European. This has no geographical significance. Whilst covered warrants may be traded at any point during their life, when they can be exercised depends on the style of issue. American style covered warrants can be exercised at any point until expiry, whereas European style may only be exercised at expiry.

Leverage

One reason investors are attracted to covered warrants is to achieve leverage. By investing in the warrant rather than in the underlying directly, investors can multiply exposure to that asset, increasing potential profits. For a higher leveraged warrant, even small price movements in the underlying will lead to greater volatility in the derivative. Warrants with greater leverage will result in increased risk. It follows that a warrant that is 'out of the money' will generally offer greater leverage than one already 'in the money'. Where investors anticipate price movements correctly, covered warrants can lead to greater profits. However, if wrong, investors lose the premium or cost of the warrant.

Hedging and Cash Extraction

A further use for covered warrants is one of reducing risk in a portfolio or holding. Using covered warrants it is possible to insure against price falls. With large built in profits, investors can be reluctant to sell - either because of continued growth prospects or because they are constrained by tax considerations. By paying a premium, covered warrants can be used to underwrite the risk. By purchasing put warrants reflective of the portfolio, investors can continue to benefit from price rises but are protected from a fall.

Another approach is the idea of cash extraction from a portfolio. Covered warrants allow the investor to take profits whilst retaining exposure to the investments. Call warrants can offer exposure to an asset at a fraction of the price of the underlying. This means that investors can benefit from future price rises without the need to hold the company shares.

Diversification

Diversification is a fundamental part of portfolio management. Certificates are another form of securitised derivative which can be used to achieve diversification in a portfolio. Tracking indices, certificates are an efficient method of achieving precise exposure to sectors and indices required in a portfolio.

Valuing a Covered Warrant

Like an option, a covered warrant's price is determined by its intrinsic value and its time value. The intrinsic value is always greater than or equal to zero. If the warrant is 'in the money' the intrinsic value will be greater than zero. The time value of a warrant diminishes, the shorter the remaining time to maturity. Because of gearing, the price of a warrant can change rapidly. Reduced volatility of the underlying or where there is a limited period before maturity may lead to the covered warrant experiencing a price fall.

Figure: Profit and loss depending on underlying at day of expiration

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Listed CFDs combine the flexibility of a CFD contract with the price transparency of a London Stock Exchange listing. Most importantly, a Listed CFD embeds a Guaranteed Stop Loss at no extra cost, which means you can never lose more than your initial margin payment, no matter how badly markets move against you. However, if the stop-loss level is hit, the position is automatically closed out. Listed CFDS work just like the unlisted versions - you pay a margin (typically between 5% and 15%) to open a long or short position on a stock, index, commodity or currency. Your subsequent profit or loss is directly based on the change in the value of the full underlying position, plus financing fees.

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Investment Trusts are more volatile than Unit Trusts, OEICs or even ETFs. This is because their share price, like any other quoted company, is determined by supply and demand and not solely upon the performance of the underlying fund. In the late 1980s and early 1990s, discounts were as wide as 30% and sometimes 40% to Net Asset Value; that is, supply for these vehicles exceeded investor demand considerably, meaning that Investment Trusts could be bought for a lot less than the sum of their parts. Given the market and industry conditions at that time, in many circumstances this did not reflect badly on the underlying investment.

More Recently

However, in recent times discounts are typically 10% to 15%. This means that investors are still able to buy shares for less than the sum of their parts, but they trade at levels much closer to their Net Asset Value. A number of factors have come into play of which investors should be aware.

• Supply exceeded demand for many technology based Investment Trusts in 1999 into 2000. These companies traded at a premium to NAV.
• The Investment Trust industry has become more efficient, indulging in share buy backs to reduce supply.
• The market has become more efficient where trusts are of a specialised nature.
• A large-scale advertising campaign has improved awareness of Investment Trusts and online brokers and financial information providers have improved access both in terms of investment abilities and information.

Do Your Research

These factors mean that Investment Trusts are more efficient than ever. Discounts remain important, but investors should be aware that a wide discount is not always the bargain it once was. In an increasingly efficient industry where most trusts are professionally managed and perform well, a wide discount may be explained by factors other than sound value. Poorly managed or unfashionable trusts will also entertain larger than average discounts and demand a degree of caution.

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Quoted companies capitalised at less than £100 million can be considered as smaller companies. Those capitalised under £50 million sit within the Fledgling index whereas others can be found in the FTSE Small Cap. A further market with some smaller companies is the Alternative Investment Market (AIM). AIM was created for younger companies and has been a successful index for the investor, consistently out-performing the FTSE All Share, although with more volatility. As discussed earlier, AIM companies are not required to comply with the same criteria as fully listed stock.

Potential and Risk

Capitalisation is only a market valuation and is not a measure of the size of a company's earnings. It is possible for a Small Cap company to generate more impressive earnings and profits than a company capitalised at twice its size. We will be exploring how you can examine the fundamentals of shares later.

Smaller companies can be a riskier proposition than blue chips partly because they have less market clout, partly because there is much less information, analysis and research about them. Due to poor liquidity, smaller companies are often unsuitable for the institutions, so little research is carried out.

Why Invest in Small Companies?

As a result smaller companies are the preserve of the private investor and the value investor in particular: imperfect information means the market is inefficient, a fact that can be exploited by the value investor. The inherent risk of smaller companies also means that the potential returns are higher. A small company has greater prospect for growth than a mature one. As the company grows, institutions become interested and the share price can receive a boost. However, value investors may have to wait a long time before the market catches up with their assessment and in the meantime, lack of interest may mean the shares underperform.

A further advantage is that private investors matter to smaller companies. Consider the fact that something in the region of 70% of the FTSE 100 is owned by large institutions with private investors owning about 30%. Private investors can rarely make a difference when voting at company meetings and the companies' strategies are usually favourable to the largest shareholders who can effectively call for the removal of the board. In the smaller company sector, the position is reversed. Private investors own something in the region of 70% of these firms, so they are sensitive to the needs of these shareholders.

Smaller company investing is more risky than blue chips and will not be suitable for all. They can be more volatile and find it more difficult to ride out periodic storms such as a strong pound affecting exports, interest rate hikes or low retail spending. Nevertheless, smaller companies can be considered as a sensible part of a balanced, long-term, diversified portfolio.

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Contracts for Difference (CFDs) and Spread Betting provide investors with new ways to use the investment markets. Rather than buy actual shares, indices, sectors, commodities or currencies, they enable you to trade on the movements, up or down, in those markets.

But it's important to bear in mind one very big difference...

Buy some shares and you stand the risk they could become worthless and you lose all of your initial investment. Trade CFDs or a place a Spread Bet and you could lose more than your initial stake, and be required to pay in to cover your position. Why? Simply this. Both are 'margined' products – you only pay a percentage of the actual investment you make. That has advantages and disadvantages and we’ll explain more about this below.

What is a CFD?
How does a CFD trade work?
What is Spread Betting?
How does a Spread Bet work?

One other increasingly important investment area is in overseas markets. Two factors are primarily responsible for this. First, the world is becoming a smaller place with investors thinking in terms of sectors rather than geographic boundaries. Major overseas companies such as Microsoft, Macdonalds and VW are familiar to investors the world over. The consolidation of stock exchanges is also providing an impetus. Second, both cost and ease of access to these markets have improved considerably with the advent of the internet, the latter also providing a depth of information not previously accessible to the private investor. The International Retail Service (IRS) of the London Stock Exchange is a listing of international securities dealt through London and settled in Sterling.

The primary advantages of including overseas stock in a portfolio are:

– Possibility of improving portfolio return

As economies move in cycles, some markets will be depressed whilst others strong, so having some exposure to other markets can create consistent returns

– Greater investment opportunities

This is particularly the case in respect of new technologies such as mobile phones, where the leading companies have tended to be Nordic

– Greater diversification

A portfolio with overseas holdings will be able to claim greater diversification by reducing market specific risk

– Exposure to sectors unavailable at home

A portfolio which invests overseas is likely to be more rounded including important sectors where it is difficult or impossible to gain exposure by investing in the home market alone; a prime example of this is the car industry where there are no remaining quoted companies in the UK, while the exchanges of Germany, France and the USA contain the largest car firms in the world.

There are, nevertheless, risks associated with international investment.

– Economic risks

A successful share performance might be negated by exchange rate difficulties. Conversely a weak performing stock might be turned to profit by a relatively strong home currency. Factors such as inflation will increase exchange rates of the overseas country.

– Political risks

Tax and other changes may inadvertently affect an overseas stock. These factors may be beyond control.

Both of these risks are increased in more volatile countries. As always, there is a balance between risk and reward.

Two other methods of gaining exposure to overseas markets in a portfolio are to use collective investments or to invest in specific shares which are, themselves, heavily exposed to other countries. Again overseas investing can be considered as a sensible part of a balanced, long-term, diversified portfolio.

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