If you are going to invest through the stock market, we had better start with what it is that you are actually buying.
You will be buying what are known as ordinary shares. You, together with all the other investors who have bought shares in a particular company, will become the owners of that company. You have a right to a say in the decision making and you share the profits through the payment of dividends.
These shares are often referred to as equities. They represent ownership of the company, just as you have equity in your house: the percentage of your house that you own when the building society’s loan is deducted.
The names of the shareholders and the number of shares held will be kept on a share register. Each time a batch of shares changes hands, the new shareholder will be recorded on the register.
There is a difference between running a company and owning it
The day-to-day running of the company will be carried out by a board of directors who may act as if they own the company but they do not. It is you, and the other shareholders, who are the owners. The directors do have the right to own shares. Indeed it is normal for them to buy shares as a show of faith in the company they are running. They have exactly the same rights as shareholders as you do.
Companies must hold an annual general meeting (AGM) to which all shareholders are invited, irrespective of how many shares they own. Votes are taken to approve the annual accounts, elect or re-elect directors, agree on the appointment of auditors and ratify the proposed dividend.
Companies may also call an extraordinary general meeting (EGM) if approval is needed for non-routine matters such as the launch of a large takeover bid for another company. Again, all shareholders must be notified and given the opportunity to attend and to vote.
The number of votes you have and the size of your share of the profits depend on how many shares you own. If you have 1,000 shares in Marks & Spencer and someone else has 10,000 shares then they have ten times as many votes as you do and they will receive ten times as much in dividends. Every share carries one equal vote.
Stocks or shares?
In the United Kingdom the two terms ‘stocks’ and ‘shares’ have become virtually synonymous but the latter (and ‘shareholders’ rather than ‘stockholders’) is normally used, so this is the term that will be used in this book.
The Americans tend to refer to ‘stocks’ but they are talking about the same thing as our shares.
Each share has a nominal value. This is basically what the value of each share was when the company was originally formed.
If you have a penny black stamp in your possession, it was originally issued back in 1840 for 1p. That is its nominal or face value, not its value today. It can be sold for whatever a stamp collector is prepared to pay for it, which will be several million pounds. Similarly, you should not expect to pay the nominal value of a share. You have to pay whatever price the share commands on the stock market. Thus it is the market value of shares, not the nominal value, that matters.
Where do shares come from?
In the first instance, shares are issued by the company when it is set up. Investors put money in to get the company going. Premises have to be bought or rented, machinery may be needed, staff have to be paid, materials bought… all this before any money comes in from customers. In return, the investors are allocated a stake in the company.
Money, or capital as it is referred to, is one of the many inputs that a company needs. Capital can come through the founders putting their hands in their pockets, from taking out bank loans or from selling shares to investors from outside the company.
The issuing of new shares by a company is known as the primary market because it is the first time that the shares have been allocated to investors. When these shares are subsequently bought and sold on the stock market, that is the secondary market.
Think of it this way. When a builder puts up a house and sells it for the first time, this is the primary market. When the house is sold on to new owners, that is the secondary market. It is exactly the same with shares.
We shall discuss the primary and secondary markets in chapter 2.
Issued capital
How many shares a company issues is decided by the company itself. There is no fixed number of shares. The number of shares will depend basically on how much capital the company has needed to raise, not only when it was first set up but also at any time subsequently.
The shares that have actually been sold by a company to shareholders are the issued share capital (this is also referred to as the called-up capital).
Do not expect a conveniently round number. For example, high street retailer Marks & Spencer, in its 2017 annual report, had an issued capital of 1,624,727,846 shares.
Part paid shares
When you buy shares you will almost invariably have to immediately pay the full amount due, but on very rare occasions you may pay for newly-issued shares in instalments.
Investors who have bought shares in privatisation issues, when the government was selling off state enterprises, may recall that in some cases payments to the government were made in instalments; the idea being that more ordinary investors would be tempted to join the great share-owning democracy if they could pay in manageable bits – just like buying a washing machine in monthly instalments.
This is a messy and expensive arrangement, since some shareholders inevitably forget by the time the next payment is due or they simply do not have the cash. Either way, they have to be chased up, which is why part payments rarely happen.
A and B shares
We have assumed so far that you will be buying ordinary shares and that these will rank equally with each other. Each ordinary share has one equal stake in the company and one equal vote.
There is one exception to this, and that is where there are two classes of ordinary shares known as A shares and B shares.
In the past, some family-owned companies tried to get the best of both worlds, raising cash by selling shares but retaining family ownership by the rather sneaky method of having two classes of shares. One class of shares, usually the A shares, had one vote each and were sold to the general public while the other class, usually the B shares, had ten votes each and were issued to the family.
Thankfully this subterfuge is now regarded as unethical and has all but disappeared. The best known name that still treats the public unfairly with two classes of shares is that bastion of moral rectitude, newspaper publisher Daily Mail & General Trust. Its A shares, the ones most widely traded on the stock market, have no votes even though there are over 300 million of them, while the 20 million ordinary shares control the company. You cannot buy the ordinary shares on the stock market so don’t bother looking for them; they are all owned by Lord Rothermere and his family.
A, B and (in very rare cases) C shares used to be widespread in the brewing industry. Two examples survive, though not to the detriment of ordinary shareholders. Young’s A shares, with full voting rights, are traded on the London Stock Exchange. There is also a class of non-voting shares, which are traded separately, so you know which you are buying. Fuller, Smith & Turner have A, B and C shares. It is the A shares, with full rights, that are traded on the stock market.
Royal Dutch Shell has A and B shares but these have equal rights and the split exists only because Shell is an Anglo-Dutch company. The A shares are for Dutch investors and the B shares for those in the UK. This is to avoid shareholders being taxed twice on their dividends.
During privatisations you may have come across the British government’s golden share, which was the ultimate B share. The government hung on to one share in each privatised company, which could be used to outvote all the other shares put together. This golden share was retained in case the government felt it needed to intervene in the national interest. Golden shares were used in the UK as a veto only twice and the European Court of Justice has ruled that they are against European law unless national interest is clearly at risk. They can now be disregarded.
Preference shares
There is one other class of shares apart from ordinary shares and they are called preference shares. These are more like loans than shares. Preference shareholders do not have voting rights except on issues that specifically affect them. They receive a set rate of interest, usually twice a year, just as you would receive a rate of interest on a savings account in a bank or building society.
It is possible to buy and sell preference shares on the London Stock Exchange in the same way that you buy and sell ordinary shares, although not all companies issue preference shares. Interest on preference shares must be paid before dividends on ordinary shares, and if the company goes bust any cash left over when the creditors have been paid off goes to the preference shareholders first. That’s why they are called preference shares.
However, we naturally hope that our investments have gone into prosperous enterprises. While the poor preference shareholders are stuck with a fixed rate of interest, we, the ordinary shareholders, see our dividends rising along with the profits of the company.
As we shall see throughout this book, investors who take the greatest risk expect to receive the greatest reward, and this does tend to happen (although there are no guarantees).
Convertibles
Companies raise money by taking out loans, usually by borrowing from the bank through overdrafts or term loans, which are loans for a set number of years. They may also borrow from the general public by issuing loan stock, also referred to as bonds, in much the same way that shares are issued (except that holders of loan stock do not own the company).
Some loans can be converted into ordinary shares. These loans are known as convertibles.
The terms on which they can be converted, and the dates at which conversion is allowed, will have been set out when the loans were issued. If the loans are at any time converted into ordinary shares, these shares will carry exactly the same rights as those of existing ordinary shares.
In some cases preference shares may be convertible into ordinary shares and will thus be designated convertible preference shares.