Chapter 1
Getting to know shares and securities

In this chapter, I outline the various types of shares and securities you can invest in. I also discuss some important terms and concepts, so you'll be able to understand the information available.

Understanding financial investment instruments and securities

A financial investment instrument is something of monetary value that can readily be traded; that is, bought or sold. These are also known as securities because of their monetary value, which allows them to be used as security for a loan.

Shares

Shares are a popular type of investment instrument or security.

The idea of share ownership originated in the early days of English exploration, when expeditions were mounted to far‐flung regions in search of riches. For those prepared to take the risks involved, a successful expedition could make them large profits. However, such ventures were very expensive and often relied on royal patronage (funding). In addition, private investors might contribute; for example, if a venture cost £10 million to mount, this might be obtained from 10 investors, each contributing £1 million. Funds obtained this way became known as equity capital because investors were part owners; that is, they had an equity in the enterprise.

Notes

• Capital is just another name for money or cash used for business purposes.
• Shares are also known as equities.
• Apart from equity capital, a business can also obtain capital by means of loans from banks or financial institutions. This capital is known as loan capital.

The idea of issuing shares to obtain equity capital for business ventures caught on in capitalist economies. Soon, several refinements were introduced. These included:

• Issuing shares with smaller monetary value. That is, instead of raising £10 million by issuing 10 shares of £1 million, the same capital could be raised by issuing 10 million shares at £1 each.
• As shares had a value, they could be traded between willing sellers and buyers. Indeed it was possible to make a profit by trading shares without actually participating in the enterprise. Originally, share trading was done at the Royal Exchange and then in coffee houses where investors gathered, but by 1748 share trading was so popular that a dedicated stock exchange was set up in Threadneedle Street, London. Soon this idea spread throughout the world and today most countries have their own stock exchanges.

Stocks and shares

The words stocks and shares are often used interchangeably but really they have slightly different meanings. Shares are the smallest equal units of division of ownership in a business enterprise, whereas stock is the sum total of all those shares. For example, all shares issued by Woolworths comprise the total Woolworths stock. If you buy some Woolworths shares, the number of shares you own determines the extent of your equity in the company — in this case, Woolworths.

Company

A company is a legal entity in its own right; that's to say in law it is regarded as a body that's distinct from the owners. This legal body is known as the ‘body corporate’ and it can do many things a person can do such as:

• enter into legal contracts
• sue or be sued
• buy or sell commodities
• hire or fire personnel
• own assets, including stock, machinery, real estate and cash.

For business purposes, the great advantage of a company is that the owners cannot be held liable for the debts or contracts of the company. This is different from business enterprises such as sole proprietors or partnerships, where there is no body corporate and the owners are liable for contracts and their assets can be used to repay debts if necessary.

Public versus private companies

As the name suggests, a public company is one where anyone can buy shares in the business and so be a part owner. This is different from a private (or proprietary) company (Pty Ltd), which is limited to 50 shareholders and the public at large can't become shareholders unless the company ‘floats’ (that is, converts to a public company). Public companies are listed on a securities exchange so the shares are available to all, whereas private companies are not listed and you cannot become a part owner unless invited.

Public companies are limited companies so their name ends with ‘Ltd’ (although this is sometimes left off in abbreviated share listings). The word limited means that, in the event of liquidation, the liability of the shareholders (owners) is limited, and the shareholders’ personal assets can't be used to repay business debts (unlike in the case of a sole proprietor or partnership). To be precise, shareholders’ liability is limited to the amount of any unpaid calls on contributing shares (if any).

A special type of listed company is the no liability (NL) mining company. NL means that there's no liability on the shareholders for unpaid calls on contributing shares (if any). (I discuss calls and contributing shares later in this chapter.)

Businesses that don't issue tradeable shares

In Australia, there are far more businesses that don't issue tradeable shares than those that do. Sole proprietors, partnerships, cooperatives and proprietary (private) companies are some of the business enterprises that don't issue tradeable shares.

Notes

• Public companies are usually larger than private companies but this is not always the case. For example, in Australia, Woolworths and Coles are public companies but Aldi is a private company of similar size owned by a single family.
• BHP is the only public company in Australia allowed to use the word ‘proprietary’ in its name, despite not being a proprietary company.

Initial public offering (IPO)

In order for a business enterprise or private company to convert to a public one, it must comply with legal requirements and also the rules and regulations of the exchange. This conversion occurs as an initial public offering (IPO) or ‘float’. The issuing company must prepare a document known as a prospectus, which outlines all relevant commercial and financial information about the business (including investing risks). Investors can obtain shares only by completing the application form in the prospectus, and an investor obtaining shares in this way is said to have ‘subscribed’ to the issue. No transaction costs are usually incurred when shares are obtained this way.

Most floats are underwritten, which means that an underwriter (such as a large broking firm or financial institution) guarantees to take up any leftover shares if the issue is undersubscribed. On the other hand, if more shares are applied for than are available, the issue is oversubscribed and investors may not obtain as many shares as they applied for.

The price at which shares are offered is determined through consultation between the floating company and the underwriter, who are trying to obtain the maximum price consistent with full subscription. From the day of listing onward, the shares can be traded on the securities exchange in which they are listed. If the market considers that the issue price has been set too low and/or the issue has been oversubscribed, the price will usually take off on the first day of trading. If the issue price is too high and/or the issue is undersubscribed, the price will usually fall on the first trading day.

Notes

• You might wonder why a business would go to all the expense and hassle of ‘going public’. One reason is that the business wants to expand and needs more capital and can't get sufficient capital from a limited number of private investors. The other main reason is that an entrepreneur wants to bring a new product or service to the market and needs considerable capital to do so.
• Company law, exchange regulations or reputable underwriters do not of themselves guarantee investors that any new listed company will be profitable and that buying shares in an IPO will prove to be profitable.
• Investors who subscribe to an IPO and sell the shares on the first day of trading hoping to make a quick profit are known as ‘stags’.

Considering different types of shares

Several types of shares are available, which I will now discuss briefly.

Ordinary shares

The most common type of share by far is the fully paid ordinary share (FPO). The adjective ‘ordinary’ is often dropped and because nearly all shares are fully paid, you can also usually assume that the word ‘share’ means ‘FPO share’. Ordinary shares are essentially ‘plain vanilla’ shares without any frills or special conditions attached.

Preference shares

Preference shares are superior to ordinary shares in some defined way, usually because they have first right to a dividend. This dividend is often set at a predetermined rate, such as at a certain margin above the prevailing bank bill rate. However, preference shares don't usually carry voting rights.

Convertible shares or hybrids

Some preference shares are...