Investing on the stock market need not be as complicated as it is often made out, Andile Mazwai, the chief executive officer of Mazwai Securities, says. At a recent meeting of the Independent on Saturday/NBS Investors Club in Durban, Mazwai cut through the jargon and gave a plain-speaking guide to the basics of investing on the JSE Securities Exchange.

Andile Mazwai, the chief executive officer of Mazwai Securities, says the basics of investing can be understood by answering three essential questions: "What is an investment?" "What is a return?" and "What is risk?"

When you make an investment you are forsaking short-term consumption for long-term reward. You give up something now in order to have something later, Mazwai says.

A return is how much you want to make within a certain period of time. You must know why you are investing, how much you want to get out of your investment, and by when you want to make it.

Mazwai says you decide on your investment risk by answering the question: "How much can I afford to lose?"

Once you have decided on your returns and determined your risk, your next step is to look for a suitable investment instrument.

Mazwai says there are only three asset classes - cash, bonds and equities - but derivatives, which depend on these classes for their value, make up a fourth investment type.

These investment instruments can be ranked according to the risks they carry. Cash (putting your money in a bank or in the money market) has the lowest risk; bonds are low-risk investments; and equities are high-risk investments. Derivatives have the highest risk.

Bonds

Bonds are fixed-income investments that provide you with a guaranteed income. They are mainly issued by the government, as well as parastatals and companies, when they need to borrow money to finance development or expansion.

Bonds are traded on the Bond Exchange of South Africa, and are normally issued in what are called round lots of R1 million. However, ordinary investors will usually access the bond market through collective investments such as a unit trust fund or a life assurance policy.

The value of bonds is determined by interest rates. When interest rates increase, the value of bonds decreases, while the reverse is also true, Mazwai says. Bond prices often move in anticipation of an increase or decrease in interest rates, and because interest rate increases or decreases are linked to inflation, players in the bond market keep an eye on inflation figures.

Let's take an example: A bond with a coupon (interest rate) of 13 percent a year costs R1 million. If interest rates jump to 26 percent, the value of your bond decreases, because an investor could get a return of R260 000 a year simply by putting R1 million into the bank, while your bond is paying a return of R130 000. In order to sell your bond, you would have to price it at say R870 000 to make it attractive. Should interest rates fall to, for example, 6.5 percent, the value of your bond will increase, as investing R1 million in a bank will yield a return of R65 000, while your bond's return is double that.

Equities

Equities can be understood by considering the hypothetical example of a company that needs to raise R10 million in cash in order to expand, Mazwai says.

Since obtaining such a large sum of money from an individual or institution would be difficult, the company breaks up the R10 million into amounts that investors can digest, and makes an Initial Public Offering (IPO) in the share market.

In seeking to raise the R10 million, the company could either make an IPO of one million shares at R10 each, or of 10 million shares at R1 each. Either way, the company will raise the same amount, and you should not make the mistake of judging whether the share is cheap or expensive based on its nominal value of R1 or R10.

To understand the concept of earnings, let's say that the company issued 10 million shares at R1 each, and made R1 million in profit in its first year of operations. The company's earnings after one year would thus be 10 cents per share (cps), while the company's shares would be worth R1.10.

The company can do three things with its profits: It can keep the R1 million as "earnings retained"; pay out its 10 million investors in cash - a dividend of 10 cps; or it can issue new shares in lieu of dividends.

Valuing equities

Mazwai says there is only one number on any income statement that you, the ordinary investor, can verify: the dividend. Looking at a company's dividend - the bottom line - is where you should start when valuing a company.

But not all companies pay a dividend - in this case, look at the profits (earnings). However, not all companies have profits, especially when they are starting out and are ploughing all their profits back into the company. In this case, look further up the balance sheet at, for example, the Earnings Before Interest and Tax (EBIT), and all the way, if necessary, to the sales figures to find a company's value.

You may find these figures confusing, in which case you should leave the company well alone, as not understanding an investment is the ultimate form of risk, Mazwai says.

It is important that you know your company, what it does, and how it makes its money. In this way, you will be able to realistically judge the returns you can expect, Mazwai says. If, for example, you are told that South African Breweries (SAB) will double its sales figures in a month, you should be sceptical. For SAB to sell so much more beer, the size of the country's beer-drinking population would have to almost double in a month.

Mazwai says his company favours using the "good old" price/earnings (p/e) ratio as a yardstick of a company's value. The p/e ratio is a guide that tells you what price you are paying to invest in a company and what earnings you can expect to make on your investment (See Price/earnings ratio).

Investment techniques

There are two schools of thought when it comes to investing: active investing and passive investing.

With active investing, you try to assess whether the outlook for an investment is either good or bad. There are two methods of doing this:

  • Value investing, which is the method used by the highly successful investor Warren Buffet. Here you establish what a company is worth, and if its value is less than the market price, you buy. Value investing is only for the brave, as it takes courage to believe that the market is wrong when it "under-values" a company.

  • Growth investing simply means believing that a company will be worth more than it is now in, say, one year's time, Mazwai says. Growth investing works well when the market is in a bull phase, but when the investment climate is bearish, you are going against the grain and need to be aware of risk you are taking.

    With passive investing, you do not try to out-perform the market, but buy into an index. Index-tracker investments perform in tandem with the market. If the market goes up or down by 10 percent, your investment does the same, Mazwai says.

    He says the Satrix investments have become a popular index-tracking investment in South Africa because investors can get into the share market relatively cheaply and they don't have to pay high transaction costs.

    Derivatives

    As their name suggests, derivatives are financial instruments that derive their value from that of other underlying securities, such as shares, or commodities, such as gold or coffee, Mazwai says. Derivatives attempt either to minimise the loss arising from adverse price movements of an underlying asset, or maximise the profits arising out of a favourable price fluctuation.

    Derivatives are complex investments, and thus not for investors who are risk-averse or who do not thoroughly understand them, Mazwai warns.

    Options are a type of derivative that gives the holder the right, but not the obligation, to buy or sell something during a specified time period. The option holder can exercise the option at any time or not at all. Warrants are a type of option (See How warrants work). Options are traded on the South African Futures Exchange, but warrants are traded on the JSE.

    Derivative trading is older than trading shares in companies, Mazwai says, and can be traced to the desire of people in agricultural-based economies to protect themselves against the risk of future price changes.

    For example, in October a farmer looks ahead and calculates that by December 15 he will harvest 10 tons of maize. The current price of maize is R100 a ton, and at that price the farmer knows he will make a profit. But what if the price drops by December 15? Should that happen, the farmer will not make profit on his crop. The farmer would thus like to freeze the price of maize to protect himself from the risk of the price falling in future. Similarly, a miller, looking ahead in October, would like to fix the price of maize at the current price of R100, so that he can be certain about the cost of purchase. Thus, the farmer and the miller enter into an agreement - a futures contract - in October to lock in the price of maize at R100 a ton on December 15 - the forward date. At the time the contract is entered into, no money changes hands - only an agreement to buy/sell.

    You can buy futures contracts through the South African Futures Exchange, where fund managers who wish to "hedge" against the risk of change in the price of an underlying asset (a share) sell futures contracts. By "hedging", the fund manager is transferring financial risk to someone in the marketplace who is prepared to take on that risk.

    Remember that with futures contracts both parties are obliged to buy/sell at the agreed upon price, Mazwai says. This may not suit you, and so you may prefer to trade in the options market, where you have the right - not the obligation - to buy or sell at a certain price. As with an insurance policy, you pay a price - a premium - in order to hold the right to exercise your option.

    In the case of warrants, you pay a premium to the seller of a warrant in exchange for the right to buy or sell a specific share at a specific price, called the exercise or strike price, by a certain date - the expiry or exercise date of the warrant.

    Mazwai warns that the "modern game" of speculating in the futures or warrants markets is very risky. You are essentially taking a bet that the price of an underlying asset will increase by a certain amount by a certain time. If you are wrong on any of these variables, you lose the bet.

    Investment discipline

    If you invest on the JSE, you have a 50:50 chance that you will make a profit - and these are "great odds", Mazwai says.

    Your biggest enemies are greed and fear, and sticking to the returns and risks you decided on when you invested is the way to overcome these negative emotions. If, for example, you decided you wanted to make a 20 percent return within six months, and your investment increases by 20 percent in two days, take your profits - don't hold out for more than you targeted. If you decided you could risk losing R1 000, you should sell once you have lost R1 000 and not a cent more.

    Mazwai says you should remember that the market is always rightE even when it's wrong. Although it is true that markets can get it wrong when valuing companies, "the market can stay wrong a lot longer than you can remain solvent".

    "Insider trading" does take place, but Mazwai says you should not get upset about it. (Insider trading occurs when people with access to information not yet known by the general public trade in shares.)

    Although insider trading may allow the market to exaggerate value, "the market does not lie". The acid test you can use when assessing how a share is performing is to look at the volume of shares that changed hands in a day. A share with large volumes and big price movements in a day indicates that you should exercise caution.

    There are two main types of warrants: A call warrant, which gives you the right buy shares, and a put warrant, which gives you the right to sell shares.

    The price of a warrant varies according to the price of the underlying share and the length of time the warrant has left to run.

    PRICE/EARNINGS RATIO

    The price/earnings (p/e) ratio shows you how the market rates a share. The p/e ratio tells you how many years it will take a company to produce the profits required to cover the amount of money you have invested. The higher the ratio, the more the market is prepared to pay to get a slice of the company's future profits. A p/e ratio is calculated by dividing the current share price by the last annual (after-tax) profits per share. For example:

    Earnings per share: R10

    Current share price:R100

    p/e ratio: 10

    In other words, it will take 10 years for the company to produce profits to cover a R100 investment.

    The higher the p/e ratio, the longer it will take to recover your investment. The lower the ratio, the greater the potential value.

    HOW WARRANTS WORK

    The advantage of a warrant is that it gives you the opportunity to profit from share price movements - in either direction - for far less money than it would cost you to buy the shares.

    Call warrants

    If you think the price of particular share is likely to rise, you can choose to buy a call warrant. As the share price rises, your warrant becomes more and more valuable, and once the share price rises above the strike price of your warrant, the warrant is said to be "in the money" because you could make money by exercising your warrant to buy the shares at the agreed price and then sell them for more on the market.

    For example, you buy a three-month warrant on shares worth R100 000. The warrant price, or premium, is what you pay for this right. Say it is R2 000. If the price of the shares on the market rises above R100 000 - your strike or exercise price - you are in the money because it will be worth your while to exercise your option, buy the shares and sell them on the market. If the price falls below R100 000, you do not have to exercise your warrant; all you have lost is your initial investment of R2 000.

    This is the key to warrants: your maximum loss is limited, but your potential profit is unlimited.

    Put warrants

    If you think the price of share is likely to fall, you could buy a put warrant, giving you the right to sell shares at a specific strike price. As the price of the share on the market falls, your warrant becomes more and more valuable, and if it drops below the strike price, you are in the money because you could sell the shares at the exercise price and simultaneously buy them on the market at a lower price.