CHAPTER 4
The benefits and risks of shares
All investments have pros and cons and since this book is principally about investing in the sharemarket, this chapter focuses on why people are attracted to shares and what they need to look out for.
Benefits
Let’s have a look at some of the benefits of share ownership.
Capital growth — making a profit
People invest in shares because they offer the potential of generating good returns if share prices rise. Investors may only intend holding the shares for a relatively short time or they may have a longer term view, but in either case they hope to make a profit.
There is a saying that you have never made a profit until you have sold, which is quite true. You might buy some shares and be in the happy position of watching their price go up, and be reluctant to sell in case they keep on going up. You might then be in the less fortunate position of watching the share price go back down again. Your paper profit was just that — on paper, because you never sold. If you do sell at a profit you may be liable for capital gains tax.
Income
Apart from buying and selling shares for profit, investors also buy shares to provide an income stream in the form of dividends.
Dividends are cash distributions from a company to its shareholders. Dividend payments are typically paid each six months as ‘interim’ and ‘final’ dividends. Companies are under no obligation to pay dividends and the amount a company pays in dividends can vary from year to year.
Australian companies tend to pay higher dividends than elsewhere and high yield stocks are especially attractive for superannuants hoping to live on investment income.
Franking
Franked dividends are dividends that have been paid out of company income which has already been taxed in Australia. These can be fully or partly franked. A fully franked dividend is one paid from profits upon which the company has paid tax at the full company tax rate. At the time of writing, the rate of company tax is 30 per cent.
It is important to be aware that not all companies will pay dividends to shareholders. The decision to pay dividends usually lies with the board of directors — and dividends are generally only paid if the company has made a profit and paid tax on its earnings. As mentioned, the company may decide to retain profits to fund its growth. This means that dividends are not a certainty. They also may not be of a set amount or paid regularly.
Some people who invest for income do so in order to supplement their income from other sources and to support their lifestyle. Dividend income is subject to income tax at your marginal tax rate in each year it is received.
Imputation credits
Imputation credits are the tax credits that are passed on to investors via franked dividends and represent the tax already paid by the company.
Dividend imputation
Investing in shares may be tax effective; however, this is a topic on which you should seek specific and independent advice from a qualified adviser.
Prior to the introduction of dividend imputation, company profits paid out as dividends were effectively taxed twice — first at the company level and then at the shareholder level when the dividends were received.
As a result of dividend imputation, investors may benefit from the fact that tax has already been paid on the income received by the company they have invested in. In some cases, this enables investors to effectively receive their dividends tax-free. However, this is not always the case. The value of imputation credits (the credits attached to dividends on which tax has already been paid) is directly proportional to the rate of tax the company has paid.
This means that, under the tax system at the time of writing, if your marginal tax rate is less than 30 per cent you will not be required to pay any tax on the fully franked dividends you receive. In addition, the unused imputation credits may be used to offset tax payable on your other income or, in the event that there is no further tax payable, are refundable to you.
If your marginal tax rate is higher than 30 per cent, you will be required to pay some tax on fully franked dividends. However, the tax payable will be reduced by the value of the imputation credits attached.
Here are a couple of simple examples. Suppose a dividend is paid and suppose the company pays 30 per cent company tax and the dividend is fully franked.
Scenario 1
The shares are held by a superannuation fund that pays tax of 15 per cent. The tax paid by the company exceeds the tax that would be payable in the hands of the shareholder so the superannuation fund would receive a tax credit of 15 per cent of the value of the dividend.
Scenario 2
The shares are held by an individual on the top personal tax rate of 49 per cent. In this case the shareholder should have paid a higher amount of tax so the shareholder will have to pay 19 per cent tax on the dividend (49 per cent less 30 per cent).
Dividend reinvestment plans
Dividend reinvestment plans (DRPs — also known as dividend reinvestment schemes) enable shareholders to receive their dividends in the form of additional shares without paying brokerage for the transaction. From the company’s point of view, this is a cost-effective way to raise additional funds from satisfied shareholders.
Dividend reinvestment schemes can be an effective way to grow your share portfolio. (You should consult your taxation adviser regarding the capital gains tax implications of purchasing shares through dividend reinvestment schemes, and careful record keeping is required.)
Company benefits to shareholders
In addition to sharing in a company’s success via rising share prices and the receipt of dividends, owning shares in a company means you receive regular performance reports and you can participate in company meetings and be offered special share issues.
Shares in different companies (and different types of shares within the same company) may carry different rights and entitlements and it is important to understand the rights attached to the shares that you intend to purchase. We recommend that you discuss this with your broker or financial adviser prior to making any financial decisions.
Annual reports and company meetings
As a shareholder in a company, you will be keen to know how well that company is performing and what its plans are for the future. Public companies are required by law to report this information to their shareholders each year in the form of an annual report.
The annual report is your guide to the company’s performance. The most important part of the annual report is its financial report.
The main components of a financial report
A financial report comprises:
- a balance sheet (showing assets and liabilities)
- an income statement (showing revenue and expenses)
- a statement of changes in equity (showing either all changes in equity, or changes in equity other than those arising from transactions with equity holders acting in their capacity as equity holders)
- a cash flow statement
- notes, comprising a summary of significant accounting policies and other explanatory notes.
Financial reports help you to find out what a company has earned during the year and the way those earnings have been distributed — that is, as tax paid to the government, dividends paid to shareholders or earnings retained to help fund the growth of the business. You can also find out how much debt the company has and where the main sources of cash are for the company. If you like reading the fine print, the ‘Notes’ are worth reviewing as many useful facts about the company’s activities can be found there.
The annual report or its attachments will also contain a notice of the company’s annual general meeting (AGM) and the business resolutions to be discussed there. After reading the annual report, you may decide to attend the AGM. Alternatively, you may decide to lodge the proxy form provided with the report to register your vote on any of the business to be discussed. Some companies are now providing the ability for their shareholders to vote electronically via their smartphones and to listen to or watch the AGM via the internet.
Whether or not you care to vote, attending the AGM will provide you with the opportunity to hear the chairperson and managing director speak on the company’s activities and outlook for the year ahead. You will also have the opportunity to put forward any questions you may have on the business at hand.
Risks
Investors should be aware of the risk/reward relationship that exists with any type of investment. In order to receive a return on money invested you need to be prepared to place that money ‘at risk’. Generally, the greater the risk associated with an investment the greater the rate of return investors should expect.
The risk of capital loss
An investment in the sharemarket is by no means a guaranteed investment.
In order to redeem the value of your shareholding you need to sell those shares on-market. If you own shares in a company that is performing poorly, it is possible that buyers may not be prepared to pay the price for which you want to sell your shares. As a result, you may be forced to sell your shares at a price much lower than what you bought them for.
What happens if you own shares in a company that goes out of business?
In the event that the company you own shares in goes out of business, its shares will no longer be tradable on the sharemarket. When a company is removed from the list of companies on the ASX, that company is said to have been ‘delisted’.
If a company you own shares in has been delisted the only way to claim back your money is if a liquidator has been appointed and shareholders receive a portion of the sale of the company’s assets.
In the event of asset liquidation, shareholders are last in the list of creditors (such as banks, other lenders and suppliers) to receive any funds that may be realised. As a result, shareholders may receive only a fraction of their original investment amount or could face the prospect of the complete loss of the amount they invested in the shares of that company.
Volatility risk
Share prices can rise and fall rapidly and investors must accept the fact that the value of their shares may fluctuate. General market risk may relate to a particular sector — for example, the resources sector may display more volatility than industrial companies. Think of the volatility of an oil exploration company in comparison to the shares of a major bank. Specific risk can relate to the performance of an individual company.
Timing risk
Because of market cycles, some companies have a higher degree of risk when the sharemarket has risen sharply and is set for a reaction. The opposite may apply when the market has gone into a strong decline and then starts to recover after showing some signs of stabilising. Not all sectors of the market follow the same price cycles.
Understanding business cycles and how different companies perform during the different phases of the business cycle may help you to manage the effects of timing risk.
The risk of poor-quality advice
Are the investment recommendations made to you supported by a thoroughly argued case or are they merely hearsay? The more reliable the information you have is, the better your decisions will be. Adopting a disciplined decision-making process may help you to minimise losses while you patiently build a portfolio. Recommendations involving high rates of investment return may fail to produce satisfactory results when taxation, ongoing fees and constant changes in investment cycles affect the performance.
Legislative risk
Your investment strategies or even individual investments could be affected by changes to the current laws. Are the companies within which you are considering buying shares in businesses that are subject to a high level of regulation? What is the likelihood of there being a change in regulations that may have an effect on the outlook for these companies?
Currency risk
If you have overseas investments, adverse moves in currency need to be considered. Your ability to convert overseas profits into Australian dollars will be affected by the prevailing exchange rate.
Individual or personal risk
This refers to the likelihood of changes occurring in personal circumstances (loss of job, illness or injury, or domestic changes such as marriage, divorce or a new addition to the family).
* * *
These are just some of the risks that are associated with an investment in the sharemarket. Learning about risk and its effect on your investments is crucial. You should clearly understand the risks associated with any investment you are considering.
In addition to your investment decisions, you need to know how to implement them; in the case of share investing this means buying and selling. Chapter 5 explains the different types of broker, getting ready to talk to one, placing orders and the paperwork you can expect when you buy and sell.