Chapter 7

Knowing When to Buy and Sell Shares

IN THIS CHAPTER

Making sure you’re ready for the market

Using fundamental and technical analysis

Analysing yourself — investor or trader?

Listening to your broker

Keeping your ear to the ground

Assessing the tax implications

The basic rule for investing in shares is to buy low and sell high. You buy shares when they’re cheap and sell them when they’re expensive. The trouble is, how do you know what’s cheap or expensive? Only hindsight tells you that for sure. You may buy a share and then see its price fall. Conversely, you may sell a share and then watch its price rise. If you sold the share at a profit, remember that you made a profit; and if you bought believing the shares were cheap, don’t worry that they’re now even cheaper.

In this chapter, I discuss the whys and wherefores of when to buy and when to sell, how to analyse the market, the differences between being a trader and an investor, and ways to keep your tax to a minimum.

Getting Ready for the Action

No perfect method exists by which you can determine the best time to buy or sell shares. Whether you’re a long-term investor or a trader focused on short-term opportunities, you have to work this out for yourself. Many people collect and interpret data in order to know when to buy and sell shares, but even the professionals don’t always get it right.

An experienced investor knows that no perfect method for determining when to buy or sell a share exists, although you can always find a salesperson or a software system that claims to have the key. If only the process were that simple! Whether they use fundamental analysis, technical analysis or even astrology, these systems are far from infallible. Don’t be fooled by software programs that promise to make you rich. If the system were foolproof, you can be sure it would be a very tightly held secret.

Before you buy or sell shares, you have to satisfy yourself that the shares are likely to rise or fall. If you’re using a software tool to give you trading tips, you have to be able to validate the information it’s giving you. Whether you do this through your own research or through consulting a reputable broker or adviser, seeking a second opinion is always wise.

When you invest in the sharemarket, the only way to have the odds in your favour is to do your homework. You have to study the companies, research their operations, review their history and estimate their potential for profit. This may require reading the company prospectus or annual report, sifting through broker research, trying the company’s products or services yourself and even talking to the directors or managers. You may decide to follow the price and the volume of trades and try to understand the many things that they imply. Read, study and ask plenty of questions — and then go back and study some more.

Loving your shares

Emotions play a part in sharemarket investing. Although buying shares means acquiring a financial asset, the main purpose of the investment is to earn money for you. If a share doesn’t perform to expectations, sell it and find one that will make you money. That’s the objective. However, when you buy a share, you’re also starting a relationship. You researched the company or read about it and you’re enthusiastic. As with your everyday relationships, the possibilities seem endless, the expectations are all for the best and you’re truly optimistic. Perhaps, if this relationship goes well and your stock makes you money, you may come to believe you could never bring yourself to sell. If that happens, you’ve lost sight of the purpose of investing in shares.

Sometimes investors are paralysed by the fear that after they sell a share the price goes higher and they could have made more from it if they’d hung on. If this happens, remember that by locking in your capital gain, you protect yourself from the possibility of loss; taking a loss on a share feels a whole lot worse than not making as much profit on a share as you could have.

A profit is only a profit and a loss is only a loss when it is crystallised — when you actually sell the shares. Price fluctuations in the sharemarket continually alter your paper profit or loss, but good or bad, the change in the value of your holdings isn’t real until you act on it.

Sometimes you may fulfil your expectations and justify your emotional attachment to the shares. When you’re ready to sell, you face two possibilities — either you’ve made money on the shares, or you haven’t. You can bank the money and pay the tax, or learn your lesson, claim the loss and get on with your life in the sharemarket.

If a share purchase goes bad, convincing yourself that the shares can return to your buying price if you just hang in there long enough is easy. However, that’s a dangerous assumption to make. Taking the loss and moving on to better investments may be more suitable.

Buying smart

To buy smart, you buy a share when it’s undervalued by the market and likely to rise in price and generate a capital gain.

You can’t know what’s going to happen to the share price in the future. However, you can make a well-informed guess, based on knowledge, research and help. You’re making an educated guess but that’s all it can ever be. Sharemarket investors and traders make these assessments every day.

Every sharemarket participant is trying to buy stocks cheaper and sell stocks at a profit. But for every buyer, a seller exists — someone whose view of the stock is the exact opposite of yours. To ensure your side of the transaction is the correct one, do your homework and trust your opinion. That way you can be confident that you’re a better-informed investor than the person on the other side. But you won’t get every decision right.

Selling smart

Usually, you sell a share when you decide it’s more likely to fall than rise. If you bought shares for less than you sold them, that’s good, and all you have to worry about is the capital gains tax. If you need cash, selling a profitable shareholding is a quick way to generate free money to spend on things like children’s education or overseas travel. I’ve cashed in shares to spend on travel, and it’s an enjoyable feeling, as though the money came out of thin air.

AVERAGING DOWN OR UP

Averaging down means buying more of a share if the price falls. Investors do this to lower the average cost per share of the holding. For example, say you bought 1,000 shares of a company at $5. The price drops to $3, so you buy 1,000 more shares. The average cost of your shareholding is now $4. Instead of the stock having to rise above $5 before you’re ahead, your break-even point is now $4. If the share price falls further, you can lower your average buying cost even more. But the risk you’re taking is that the stock never recovers, in which case all you’ve done is throw good money after bad.

For example, anyone who averaged-down into Dick Smith Holdings or Slater and Gordon or RCR Tomlinson (refer to Chapter 4) after they began their terminal slides, and who thought they were lowering their average cost, turned out in the end to hold a one-way ticket to oblivion — unless they eventually claimed the capital loss (see Chapter 10). Averaging down only works if a stock recovers and then moves higher than your average buying cost. When you average down, you’re taking a big risk, but you can make it work in your favour if you confine it to stocks that you research thoroughly. Then, when the market overreacts to a piece of news and dumps the stock temporarily, averaging down can pay off. Many investors used the February–March 2020 crash, for example, as the opportunity to average down.

As I mentioned in Chapter 3, even some of the market’s biggest long-term success stories, such as CSL, have given investors the occasional opportunity to average-down. Fortescue Metals Group is another, over its journey. And that raises one of the drawbacks of the averaging-down strategy — its success really only becomes obvious in hindsight.

Specialist baby goods retailer Baby Bunting is another example. Baby Bunting floated on the ASX in October 2015, and surged from its issue price of $1.40 to $1.99 on its first day, a 42 per cent gain. Let’s say, fortunately for you, you received 1,000 shares in the initial public offering (IPO).

The shares more than doubled within a year of listing after the company beat prospectus forecasts. Happy with how the company was performing, say you then bought another 1,000 shares at $2.60 in August 2016 — taking your average buying price to $2.

However, things then started to turn sour for Baby Bunting, as investors started to worry about rising competition in the baby goods sector, intense discounting by rivals and fears about the imminent arrival of Amazon Prime, given that Amazon is a major player in the baby goods category in the US.

The share price ebbed lower and lower, until, at Baby Bunting’s annual general meeting in November 2017, the company upset investors with an earnings guidance downgrade, and the shares fell back through their issue price of two years earlier.

In investors’ minds, it seemed that Amazon was apparently going to kill off local retailers. In vain, Baby Bunting tried to reassure investors that it expected to be cheaper than Amazon for about half its product range and that more than half its top 250 selling goods were subject to Australian mandatory safety standards, which Amazon Prime may not have been able to match.

Say you believed the company rather than the market, and bought another 1,000 shares at $1.40, in March 2018.Clearly your initial IPO stake was not making money, but you now owned 3,000 shares with an average buying price of $1.80.

After that, it was time to sit back and watch as Baby Bunting was able to ignore a generally weak retail environment and move to a dominant position in the $2.4 billion baby goods market, gaining a 12 per cent share. The company watched four of its biggest competitors, including Babies ’R’ Us and Baby Bounce, go out of business. The company smashed expectations when it reported results for FY19 and, by late 2019, the shares were trading at $3.90 — more than twice your average entry price.

The COVID-19 crash stripped the Baby Bunting share price back to $1.65. Since I’m setting out this case study with the benefit of hindsight, I’d love to say that you snapped up another 1,000 shares at that price and lowered your average purchase price for BBN to $1.76 — but that’s probably too perfect because it means you would been brave enough, and clever enough, to pick that March 2020 bottom. In any case, Baby Bunting is back above $3.20 at time of writing. Averaging down has worked because Baby Bunting is a high-quality stock that got into an over-sold position, but has risen strongly as the strength of its business model has come to the fore.

‘Buying the dips’ in a high-quality stock can decrease your average cost and increase your capital gain — assuming that the ‘dips’ turn out to be temporary.

‘Value’ equity fund managers are quite prepared to average down, on the grounds that if they like a stock at $10, they like it even more at $5. Of course, that approach assumes that they have researched the stock thoroughly, and they believe that the market is missing something that they know.

On the face of it, a better strategy is to average up; that is, as a company’s share price increases, you should buy more of its shares. The theory here is that while you increase your average buying cost, the company is also prospering, the good news is flowing and the stock is steadily rising. In averaging up, you’re putting more money into your winners. That’s true, but your investments are following the law of diminishing returns. Averaging down — if it works — adds a lot more value.

Another method of averaging is dollar-cost averaging, which involves making regular investments of the same amount of money in a stock or managed fund. You’re not trying to predict the best time to buy, but dollar-cost averaging makes market fluctuations work for you because you buy more shares when prices are low and fewer shares when prices are high. In short, it takes the emotion out of investing.

This strategy can help to ensure that you’re not too exposed to falls in the market when you buy at the top. The strategy can also reward you when the market recovers, through buying when the market was falling. Dollar-cost averaging doesn’t need you to have the skill or the advice to help you pick the tops and bottoms; because it doesn’t depend on the timing, dollar-cost averaging over time can smooth out the market’s ups and downs.

Dollar-cost averaging is most effective in a long-term saving strategy, and it’s actually how most people invest in the sharemarket through superannuation, through their employer’s regular compulsory super contributions. Similarly, most salary-sacrifice contributions are made via regular contributions.

Fintech company Raiz has linked the dollar-cost averaging strategy to micro-investing and exchange-traded funds (ETFs), and automated it to give investors a very low-cost way of starting to invest in the sharemarket. The company’s Raiz app allows investors to start investing with as little as $5, and users can invest small amounts regularly into a mix of ETFs that are arranged in six different portfolios selected. While investors can also invest lump sums and occasional top-ups, the central focus of the strategy is investing small amounts regularly — and getting started in sharemarket investment early. It is a good way of overcoming people’s fears that they need a large amount of money to start investing in the sharemarket, and getting its long-term compounding track record working for them.

Share purchases can go wrong, and you may have to sell shares for less than you paid. In such a case, if you’re a disciplined share trader, you may have a concrete rule on how much you’re prepared to let the share price fall before you sell. If you’re a long-term investor, you may be prepared to ignore the price fall to salvage something from a disaster.

The good news is that the Australian Tax Office (ATO) allows you to use your capital losses to offset against the capital gains that you’ve (hopefully) made on other shares in that or future years.

In the absolute worst-case scenario, if you buy the wrong share, you can lose all your investment. This can happen even if you do your homework and satisfy yourself that the shares are a good buy. That’s part of the risk.

Going into Analysis

Two tribes seem to dominate the sharemarket according to the pundits — the fundamentalists (fundies) and the technically oriented (techies). Fervent followers of each school exist. Professionals say that fundamental analysis tells you which shares to buy or sell and technical analysis tells you when to buy or sell. I don’t believe these are exact tools, but they’re useful and investors can profit from knowing how to apply them.

Fundamental and technical analysis are not for everybody, and peaks and troughs on a share price chart can be seen only with hindsight. However, these tools can be helpful.

Using fundamental analysis

Investors make their decisions based on fundamental analysis. Fundamental analysis concentrates on the financial health of the company, as shown in its regularly published accounts. Among the most important indicators are

• Profitability
• Dividend yield
• Cash flow
• Assets
• Owners’ equity
• Liabilities

Fundamental analysis involves relating the company’s reported numbers to its price to work out whether the market price is cheap or expensive. It’s used to measure risk and to find out whether the company’s financial situation is improving or deteriorating. One of the drawbacks of fundamental analysis is that company accounts are furnished only every six months or, in the case of new companies that have listed on the stock exchange without a track record of profitability, every three months. These companies are required to post a statement of cash flows every quarter. Using fundamental analysis, you may spot a trend and try to confirm that trend in the next issue of company statements.

Fundamental analysis is a tool best suited for medium- to long-term investment. Fundamental analysis doesn’t suit a trading strategy because it relies on out-of-date data. Four important calculations in fundamental analysis are the price/earnings ratio, the dividend yield, and interest and dividend cover. Other areas that are worth close investigation are gearing, asset backing and cash flow.

Determining the price/earnings ratio

The price/earnings ratio (P/E ratio) is a basic tool of fundamental analysis. The P/E ratio is the share price divided by the earnings. The P/E ratio compares the share price to the earnings and determines the value of the earnings bought at that price. Analysts use the P/E ratio to compare companies against their own track record, their industry peers and against the overall market.

To calculate the P/E ratio, you can either use the company’s reported earnings from its most recent financial year annual report or the prospective earnings forecast by broking firms. Investors who use an historical P/E ratio feel it shows actual figures based on real earnings, whereas those who use a forecast figure are trying to look into the future. Last year’s earnings are cold hard fact, whereas prospective earnings estimates are not. Then again, buying shares means forecasting future growth.

Experts used to argue that investors should look for a company with a low P/E ratio. The general rule was that a value of 10 or lower was cheap and that 20 or above was expensive. However, analysis can be a bit more complicated. For example, a stock may have a P/E ratio of 20 because its growth prospects are better, and the market is prepared to pay a premium for it, or a stock may have a P/E ratio of 8 because the market feels the stock won’t grow. These days, investors understand that the market goes through phases in which these parameters change. For instance, the market is grappling at present with the question of what are fair P/Es to pay for Australia’s technology-oriented ‘growth stocks’ (refer to Chapter 5).

A P/E ratio on its own doesn’t tell you much. You have to use this calculation as a comparison. For example, you can compare a company’s P/E ratio to the following:

• The average P/E ratio of its sector group — for example, banks, transport or telecommunications
• The average P/E ratio of the market as a whole
• The history of the company’s P/E

By using these comparisons, you can see whether the share is rated at a premium (relatively overvalued) or at a discount (relatively undervalued). Comparing P/E ratios can show you whether the share price of the company is too high or too low.

The American fund manager John Neff built his career on low P/E ratio investing, looking for P/E ratios 40 to 60 per cent below the market average. He says:

Low P/E stocks can capture the wonders of P/E expansion with less risk than skittish growth stocks. An increase in the P/E, coupled with improved earnings, turbocharges the appreciation potential … Unlike high-flying growth stocks poised for a fall at the slightest sign of disappointment, low P/E stocks have little anticipation, no expectation built into them. Indifferent financial performance by low P/E companies seldom exacts a penalty.

A low P/E ratio can be that way because the market doesn’t rate it very highly. Successful investing is about finding opportunities in shares that are undervalued, but not all of them go on to be winners. Sometimes a dog is a dog.

Calculating the dividend yield

To calculate the dividend yield — the percentage return of dividend income from a share investment — divide the dividend by the share price and multiply by 100 to convert to a percentage.

You can’t compare the dividend yield to the yields on other investments because the dividend is only part of the earnings stream of the company. Some of the earnings are retained or reinvested in the business, and the dividend yield doesn’t account for any capital gains (or losses) on the shares.

However, you can compare the dividend yield of the company to the same areas as you did with the P/E ratio; that is, other companies in its sector, the market as a whole and company price history. These comparisons can reveal whether the share is relatively overvalued or undervalued. You want to buy shares with a high yield and sell shares with a low yield. The dividend yield falls as the price rises.

You need to be careful because a high yield can be a sign of distress (remember risk versus return). The moral here is that you can’t use dividend yield or any single determinant on its own as a guide to buy or sell.

Finding interest and dividend cover

Interest cover denotes the number of times that earnings cover (can pay for) interest payments. If this ratio is less than 1, it means the company will be unable to pay its current interest obligations. An interest cover of 3 is adequate, while 2 or below is cause for worry. An interest cover level better than 3 means that during periods when earnings are under pressure (such as the post-COVID-19 period for many companies) the company will have a better chance of still being able to meet its interest payments from earnings. An interest cover of 5 or above means that the company is very well-managed. Also, many companies have debt covenants (agreements with their bankers) that require them to maintain an interest cover ratio above a certain threshold.

Dividend cover is the ratio of earnings to the dividend. A ratio above 1 shows that the company has earnings left over after paying the dividend. A company with a dividend cover above 2 is considered highly reliable — the dividend comprises less than half of the company’s earnings for the year. Dividend cover below 1 means that the company needs something more than earnings to pay its dividend. Companies can borrow from their reserves of retained earnings from prior years to pay a dividend. As a one-off situation, this is fine, but it’s not sustainable in the long run and is usually considered a warning sign.

Mature companies have a lower dividend cover because they don’t need to retain cash to finance their growth. The dividend cover is the reciprocal of the dividend payout ratio, and with the average dividend payout ratio of the S&P/ASX 200 companies being about 67 per cent, the average dividend cover for the index cohort is about 1.49 times. This tells you that the S&P/ASX 200 companies feel a lot of pressure to maximise their dividends — which could be because self-managed superannuation funds (SMSFs) own somewhere between 15 per cent and 20 per cent of the sharemarket, and they gravitate to the biggest dividend payers.

Using gearing

Gearing describes the ratio of borrowings to shareholders’ equity (or shareholders’ funds). A company finances assets from shareholders’ equity or through liabilities to external creditors. The gearing (or ‘debt-to-equity’) ratio shows the relative proportions between these two funding sources. Gearing is measured by dividing net debt by total equity (assets plus liabilities).

During good economic times, companies with a high level of gearing generally deliver higher returns to investors. But when the tide turns — as it did in early 2020 — investors find that highly geared companies have much a riskier financial structure. Some (as many did) have to raise equity to pay down some debt. Most companies in the S&P/ASX have a gearing ratio between 25 per cent and 35 per cent, which is quite conservative.

Generally, the lower the gearing ratio, the stronger the balance sheet — but relatively high gearing can be okay if a company has a reliable enough underlying cash flow to service (pay off) the debt. Anything over about 80 per cent warrants further investigation.

A negative debt to equity ratio means that the company’s debt minus its cash, divided by its equity is negative. That’s a good thing! In fact, when it comes to gearing, ‘net cash’ status — where the company has no gearing because its holding of cash and cash equivalents exceeds its liabilities, is as good as it gets. Although occasionally, analysts criticise such companies for having a ‘lazy’ balance sheet — implying that they should take on some level of gearing to boost their return on equity. However, net cash means that a company is effectively self-funding.

ASX companies boasting net cash status at the time of writing included South 32, Xero, Beach Energy, Premier Investments, The Reject Shop, WiseTech Global, Gold Road Resources, Webjet, Shaver Shop, Fortescue Metals Group, Codan, Afterpay, BSA Limited, Altium, Medibank Private, Sims Limited, HT&E, Alkane Resources, Objective Corporation, Nick Scali, Cochlear, Evolution Mining, Regis Resources, Netwealth Group, Kogan.com, Pro Medicus, Nanosonics, Clinuvel Pharmaceuticals, Bravura Solutions, Sandfire Resources, Data#3, HUB 24, Jumbo Interactive, Temple & Webster, Class, Praemium and Jupiter Mines.

Understanding asset backing

Theoretically, each share represents a share of the company’s assets, not counting debt. The net tangible asset (NTA) backing is a figure based on the assumption that if the company were dissolved and all its debts paid, these assets would be left to be sold. Intangible assets are not counted in this figure.

The market price of a share should be higher than its NTA backing. Ideally, a price premium would exist because the business is flourishing, selling its goods or services, and being well managed. A company that’s trading below its NTA backing is cheap, but this may be an indication that it won’t survive. Price-to-NTA (called ‘price-to-book’ in the US, as in, ‘book value’) is a good indicator of relative value, but don’t use it on its own.

Watching the cash flow

A company’s gross operating cash flow comes from selling its product or service. From this, you deduct the cost of these sales, such as paying staff, advertising and marketing costs, research and development expenses, leased assets, and other working capital outlays. Other deductions include any dividends or interest paid and income tax paid. What is left over is net operating cash flow. If net operating cash flow is positive, the company is generating cash. When it’s not positive, the company is consuming cash.

A company with negative cash flow can turn this around and bring in cash through its investing activities or by selling businesses, shares, intellectual property or any other assets. The company can receive cash from dividends on its investments, make further issues of equity or options, or borrow from banks or other sources. However, funds garnered from investing or financing are only an adjunct to a company’s main activity, which is selling products or services. If a company can’t generate positive operating cash flow, investors become wary of purchasing shares.

Working with technical analysis

Technical analysis is the study of the changes in the price and volume of a share that have occurred over a period of time. Using technical analysis, you can chart the share’s history and begin to make extrapolations and projections about the share. Ideally, this kind of analysis allows you to make predictions about where the share price will be at a given point in the future. You can also use technical analysis to study an index or a currency, or any commodity that is traded and sold.

On any share price chart, you can draw a trendline using technical analysis. When an upward trendline is breached, the signal says sell. When a downward trendline is breached, the signal says buy.

Charting resistance and support levels

A resistance level is a point on a chart that the share price has historically not been able to break through, and from which the share price has fallen away. If the stock is approaching a resistance level, its track record may indicate a sell. But if the stock manages to move through resistance, it’s generally headed higher.

A support level is a point on a chart at which the share price has historically rebounded. If the stock is approaching a support level, its track record may indicate a buy. But, if a stock falls through a support level, traders sell the stock as soon as they can because it’s heading for a lower support level.

Following a moving average

The moving average (MA) can appear on a chart in the form of a curving trendline. If you take a specified period of consecutive price data and divide it by that number of time periods, you get the MA. For example, you can take the last 20 days of closing prices, add them together and then divide by 20 to produce a single price. You can plot this price on the chart alongside the market price.

A moving average identifies a trend after it has already started and is known as a lagging indicator. When the price closes above the MA, it’s a buy signal, and when the price moves below the MA, it’s a sell signal.

Understanding breakout trading

A breakout trade is a form of share buying based on trend theory. When a stock is on an uptrend, it forms a series of waves with higher highs and higher lows. When the share breaches a wave high or a long-term resistance level it means that the share’s uptrend is confirmed. Buying at this point is termed a breakout trade.

Breakout trading sounds strange to novice investors who think that success comes from finding a stock that’s languishing near its lows and watching it return to its highs. Breakout trading seems contrary to logic. How can a share be a bargain when it’s at its highest price? The answer is that if the uptrend continues, that current price is ultimately a bargain.

Investing or Trading

Investors and traders have different goals when they buy and sell shares. An investor wants to identify stocks that provide maximum capital growth over a long period of time. A trader buys and sells shares to make a profit without a preconceived idea of how long to hold the shares. This is how they differ:

• Investors look for a promising share prospect with low risk and the possibility of increased capital gain. They research the company, understand risk versus return and know that earnings affect share prices. Investors want the right stocks at the right price, and they believe that sooner or later, the share price is going to rise. They’re patient and prepared to wait for the true value of their shares to be reflected in the share price.
• Traders move funds in and out of the sharemarket; whether they’re buying or selling doesn’t matter. A trader expects to take an amount of money and use it to buy blocks of stocks, which the trader can sell for a profit. Not all the trades are going to be successful, but an experienced trader with a disciplined approach expects to make more profits than losses.

Buying as an investor

Investors look for particular elements when buying shares. They want a stock that’s predictable and shows growing earnings. They want a share in a successful company to show a profitable trend within five years. Investors may allow a year of flat or even declining earnings, but in the remaining four years, they want earnings growth of at least 15 to 20 per cent a year. The company’s business and the sector of the economy in which the company operates must show the potential to create this earnings growth.

Other factors investors are interested in when buying shares include:

• Capable management: Investors want to see a settled board of directors and a management team that can demonstrate a track record of success; they also want to know that these people own shares in the company.
• Reasonable price: A share with a rising trend in earnings, which trades on a low P/E ratio relative to its peers and the market, is just what an investor looks for.
• Low gearing: The lower the borrowings, the better, because the less interest a company pays, the higher the proportion of earnings that’s ploughed back into the company and the greater the dividends for shareholders.
• High cash flow: A company with a strong cash flow from its business is effectively self-financing and less prone to external shocks, such as interest rate rises.

Efficient market theory is a point of view that says the market knows all there is to know about every stock at any time and values each of them accordingly. However, investors know that at any time plenty of undervalued gems (and overvalued stocks) are in the market and, with a bit of diligence, you can find them.

Selling as an investor

Investors sell a share when it delivers the return they expect or if the share’s story changes and the risk of holding it increases. Investors also sell because of financial need. You may have to finance an emergency or settle a long-planned-for payment. You enter the sharemarket to see your capital grow and build wealth. You can cash in part of this wealth at any time — for the children’s school fees, a new car or an overseas holiday. Shares are a financial asset that store buying power today for future use.

Investors who adhere to the buy-and-hold strategy don’t want to sell. They’re trying to replicate the miracle of Westfield Holdings (refer to Chapter 3). If you had invested the equivalent of $1,000 in the float of Westfield in September 1960, and reinvested every dividend and bonus that Westfield had paid to you, by December 2017, when Westfield left the sharemarket (taken over by French-Dutch commercial real estate company Unibail-Rodamco), your investment would have been worth $440 million.

KEEPING THE DIVIDEND

A listed company usually fights tooth and nail to keep one major status symbol. It isn’t S&P/ASX 200 index status, it isn’t a sumptuous glass-and-granite Sydney or Melbourne CBD address, and it isn’t an investment-grade credit rating. What’s really sacrosanct — once first achieved — is the dividend.

Companies typically pay dividends as a partial distribution of company profits. Whatever they don’t pay as dividends goes into retained earnings, which are reflected in the Statement of Financial Position as an increase in shareholders' equity. Companies face the decision on how much to pay out in dividends — the payout ratio — but many are very unwilling to reduce the dividend when profits are lower, worried that the market could construe it as a negative signal in relation to the company's recent performance and future prospects.

This has created the expectation that solid companies — certainly companies that think of themselves as blue chips — always lift their dividend. But it isn’t as simple as this. The argument is sometimes made that a hefty payout ratio is a sign of a company that can’t find suitable options to invest its capital. The investment-versus-dividend dilemma is a constant one for companies.

This dilemma has only increased over the last decade, as interest rates declined and returns from yield-bearing investments like term deposits ground ever-lower.

With income-oriented investors in despair at paltry sub-2 per cent term deposit yields — and the outlook for interest rates indicating that official rates could go even lower — investors are having to look further and wider for income than ever before. The income aspect of share dividends has become a major attraction, with investors prepared to take onboard the fact that the dividends cannot be considered certain until they are paid. Dividends are paid at the company’s discretion, and can be cut at any time — even abandoned.

Some of these ‘term deposit refugees’ who flocked to the sharemarket looking for yield seemed to believe that share dividends were some sort of annuity that they could bank on; however, this belief started to wane in 2017 when Telstra warned the market to expect lower dividends in future. Telstra maintained its FY17 dividend at 31 cents, but surprised the market with a new dividend policy — the company told investors to expect 22 cents, fully franked, in FY18, including both ordinary and special dividends. Prior to the announcement, the analysts’ consensus had expected 29.6 cents in FY18. Given how attached Telstra shareholders were to their dividends, this caused a Telstra Tantrum: TLS shares fell 20 per cent.

Telstra demonstrated the price risk that income-conscious investors run when they are treating shares as dividend cows. When the dust settled, however, Telstra was still offering investors a decent yield, supported by the attributes of the dividend imputation system. At 6 per cent before franking, that yield was effectively worth 7.2 per cent to a SMSF in accumulation phase (that is, paying 15 per cent tax) and worth 8.6 per cent to a SMSF in pension phase (when it is paying pensions to all of its members and is thus untaxed).

After 11 straight years of stable or increased dividends, FY18 saw Telstra’s dividend fall; and it also came down in FY19. From 31 cents in FY17, Telstra shareholders received just 16 cents per share in FY19.

The big banks, too, showed that dividends were not 100 per cent certain, with a series of cuts — once considered by investors as unthinkable. ANZ Bank cut its interim dividend in 2016, and slashed its franking level in its final dividend for FY19 from 100 percent to 70 percent. from 100 per cent to 70 per cent.

Westpac cut its final dividend for FY19 from 94 cents to 80 cents, its first dividend cut in a decade. National Australia Bank also bowed to the inevitable and lowered its interim dividend from 99 cents to 83 cents in 2019, its first dividend cut in five years.

Then, in the COVID-19 market crash and economic downturn, the banks (as with many companies) showed that in drastic circumstances, even a lowered dividend is still a dividend — while NAB slashed its interim dividend for FY20 from 83 cents to 30 cents, ANZ deferred its FY20 interim dividend completely in April 2020, as did Westpac.

The other main risk of relying on shares for income is that while you are holding the shares for yield, the share price can fall — just ask Telstra’s legion of retail shareholders, who watched their yield source fall 58 per cent in value between February 2015 and June 2018.

Dividends aren’t a bonus for owning shares; over long periods, the dividend return typically delivers just over half of your total return from owning shares.

You can’t take the money with you, but shares can play a major part in building inheritable wealth for your family. Even if you’re a buy-and-hold investor, you’re wise to continually monitor your share portfolio. Ask yourself if you’d buy the stock today. If the answer’s no, you should think about selling it and reinvesting the proceeds in a stock you’d like to buy.

The doyen of the buy-and-hold strategy is Warren Buffett of the US investment company Berkshire Hathaway. Buffett is a phenomenally successful money manager, and his company has what it calls ‘permanent holdings’. But Buffett does sell when a stock is overvalued or even undervalued. According to Philip Fisher, you hold on to a share until it has done the job, or its circumstances change, and you don’t think it ever will do its job.

Buying as a trader

If you buy a stock expecting to sell it in a matter of days, even hours, then you’re not an investor, you’re a trader. Trading in the sharemarket is okay if you know what you’re doing and accept the risks. If you try to compress the wealth-creating power of the sharemarket into a short time frame, the sharemarket gods can get very angry.

Traders don’t worry too much about the fundamentals of a company, particularly if they’re day traders. As the name suggests, day trading is the buying and selling of shares within the same trading day. Day traders are also not too concerned with the P/E ratio of the stock. The P/E ratio is only a consideration for those who are committing money to the stock for a period of years. Traders are concerned with price movement and volume; that is, the technical indicators and the price momentum of the stock.

Day trading is a particularly difficult and stressful form of share investing that’s decidedly not for the novice or the long-term average investor. Although knowing how day traders operate may be interesting, I must caution you that this kind of investing is only for professionals.

Selling as a trader

A trader sells when their shareholding drops to a specified point. When a trader buys, they put a stop-loss (or ‘falling sell’) in place that stipulates the amount of loss they’re prepared to take before selling the shares. Stops are set in terms of a dollar (or percentage) amount, or they’re set using some form of technical parameter, such as when a moving average is crossed. Although the trading mantra says to let profits run, a trader may also decide, after reaching a certain amount of gain, to get out of the trade and look for the next profitable share. Instead of a stop-loss, you can call this a stop-profit because that’s exactly what it does. To the trader, though, the operative word is ‘profit’.

Relying on Your Broker

You can’t rely completely on your stockbroker. Although some of their buy recommendations may be good investments, selling is another matter. Stockbrokers talk about underweighting a stock, lightening it, reducing it or even trimming it, but they rarely bring themselves to say ‘sell’. Some subscription-based investment websites and newsletters, however, are wholly independent and answer only to their subscribers, and are quite willing to make ‘sell’ calls.

Sell calls can cause problems for a broking firm. Companies don’t like having their shares rated ‘sell’. A disgruntled company can blacklist a broking firm from analysts’ briefings, conference calls and site visits. If the broking firm has an underwriting arm, a sell recommendation can be even more problematic. The broking firm can forget about any underwriting work from companies it describes as sells. Supporting issues in the after-market (the days after a stock is floated) is an important part of getting underwriting and if the broker has been unfriendly, the work won’t be there.

Brokers make their money when people buy or sell shares. In fairness, brokers spend more time and effort on buy recommendations because they’re directed at an unlimited number of people; that is, anyone who sees the recommendation is a possible buyer. However, only those people who own the shares can sell them — unless they’re short-sellers (see the sidebar ‘Selling short’ for more).

A common complaint of the small investor is that ‘my broker never tells me when to sell’. Even if brokers were convinced that a share was about to fall and had the time to call every client on their lists, they probably couldn’t get to every client before the share price fell. Brokers naturally want to take care of their best clients first because they pay their wages.

SELLING SHORT

‘He who sells what isn’t his’n, Must make it good or go to prison.’ This mantra of legendary 19th century Wall Street trader Daniel Drew is no longer true in terms of prison, but anyone who sells shares short and gets it wrong still pays a hefty price.

Short-selling is a reverse of what you’re meant to do on the sharemarket. Short-selling is selling a stock first and buying back the stock later. You don’t have the stock when you sell it; you have to borrow it from someone and then sell it. Then you buy it back. Short-selling is rife in the US markets but not so popular in Australia.

Short-sellers profit if the price falls. Then their selling price is more than their buying price. They pay their fees and borrowing costs and pocket the difference.

If the price rises, the short-sellers are in trouble. To cover their short position — because they have to deliver the shares they’ve sold — they have to buy the shares back on the market. If the price has risen, they’ve paid more than their selling price. For this reason, short-selling is definitely not for the inexperienced sharemarket participant.

Because you don’t own the shares when you sell them short, you must borrow them from someone. Stockbrokers and institutional investors can lend the shares to you, but they charge a borrowing fee and also require collateral for the loan. If your broker permits short-selling, the Australian Securities Exchange (ASX) requires the broker to obtain margin cover of 20 per cent of the trade value before placing your short-sold order. If the price of the shares you’ve short-sold rises by more than 10 per cent, you must provide additional margin cover of 100 per cent to your broker.

Because of the ASX’s T+2 settlement period, a short-sold position must be settled within two days; if not, a hefty fail fee will apply. Therefore, to make a profit, the price of the shares must fall within two days. You buy the shares, deliver them, pay your broker’s fees and borrowing costs and pocket the difference.

The ASX and the Australian Securities and Investments Commission (ASIC) maintain a list of the approved securities that may be short-sold, and which shares are being short-sold. In early 2020, 519 stocks were on the list, which is updated daily. No more than 20 per cent of the shares on issue may be short-sold. Short-selling is not allowed when:

• The stock is under a takeover offer.
• The order price is lower than the last sale price.

Short-selling is a common strategy employed by managers of hedge funds and absolute return funds, many of whom run long-short funds, which simply aim to capture returns from both rising and falling share prices, within the same fund. In this way, the funds can, in theory, generate a positive return no matter how the sharemarket (or other financial markets) are performing.

Such funds have been termed alternative investments and rose in popularity among retail investors annoyed at the losses posted by their Australian and international equity funds in the early 2000s. But not all of these funds were able to perform well in the GFC, losing too much on the ‘long’ side.

Short-selling was blamed for some of the excessive volatility at the peak of the GFC market turmoil in late 2008, and for some of the large price falls in stocks targeted by the short-sellers, particularly financial stocks. Some short-selling by hedge funds was deliberately targeted at stocks in which key executives had margin loans to buy their shares; the short-selling triggered margin calls, which pushed the share price even lower and had a disastrous impact on market sentiment.

In response, in September 2008, ASIC and the ASX temporarily banned short-selling. The ban was lifted in May 2009 for ‘covered’ short-selling, where the sellers had borrowed the stock before selling it; but ‘naked’ short-selling (where the sellers never even borrowed the stock) remained banned. Following the ban, ASIC and the ASX introduced stricter disclosure rules for covered short-selling.

Because of the clampdown on short-selling, many brokers no longer offer it unless the investors are ‘wholesale’ investors, meaning that they are either professional investors or are investing a minimum of about $500,000.

Many traders prefer to short-sell through online share trading platforms. In Australia, two main products are used to do this.

Contracts for difference

Contracts for difference (CFDs) are derivative investment products that allow you to speculate on prices without actually owning the shares. This means that CFD traders can profit whether the prices of stocks, commodities or currencies are going up or down. However, investors must understand that CFDs are complex and risky financial instruments, and many investors lose money this way. Based on a sample of 12 Australian licensed CFD providers, an ASIC report at the height of the COVID-19 crash estimated that retail clients lost just over $428 million gross (or $234 million net) during the week 16–22 March 2020. The 12 CFD providers studied represent about 84 per cent market share of retail CFD trading.

ASIC found that many retail CFD client accounts went into negative balance in the week commencing 16 March 2020. A total of 5,448 retail client accounts of the 12 providers in the sample (or 2 per cent of their retail client accounts that traded during that week) went into negative balance to the value of over –$4 million in aggregate. That is, they lost their initial investment and owed a further $4 million to the CFD providers.

Options trading

You can buy an exchange-traded option (ETO) on a stock that allows you to sell it at the initial market price within the option's expiry date. If the price goes down, you sell, buy back at the new price and make a profit. If the price goes up, you don't sell at all and only lose the value of the option, thus limiting the risk. With traditional short-selling, you can buy back whenever you want (unless the stock owner claims it back), whereas options normally have a fairly short expiry date.

Looking and Listening

Knowing when to buy and sell shares means that you need to be attuned to what is happening in the business community. You need to do your research, and you also need to be aware of events such as takeovers, profit warnings, index changes and more.

Analysing takeovers

A hostile takeover bid is an emotion-packed event for the sharemarket (refer to Chapter 3). If more than one company is involved and a bidding war ensues, the rest of the sharemarket eagerly watches the protagonists slug it out. The shareholders of the sought-after company have the most to gain, mainly because a takeover usually boosts the share price.

When a company’s share price is beaten down, or one of its competitors sells its business for a large amount of money, speculators look for possible takeovers. Market rumours swirl around potential takeovers, and some traders buy on rumour, hoping to sell on fact.

Any company listed on the sharemarket is up for sale, from the biggest blue chip to the smallest minerals explorer. Anybody can come along, any day, and lay money on the table. If the price is right, the board has a duty to recommend that shareholders accept it.

Taking note of profit warnings

A company announcing a downturn in profits means its investment story has changed for the worse (refer to Chapter 3). The opposite is true for an upgraded profit forecast. Traders often act quickly when they hear a profit warning. However, as an investor, if you don’t believe that the long-term outlook for the company has altered and yet the stock is suddenly substantially cheaper, you may want to buy more shares. When a profit warning does alter the long-term prospects of a company, you can then think seriously about selling the shares.

Watching index changes

Thanks to the growth of index funds and exchange-traded funds (ETFs), changes to the composition of the major indices bring both guaranteed buying of the stocks added and guaranteed selling of the stocks discarded, as institutions alter their portfolios to reflect the new make-up of the index. Trading on index changes is short-lived, but generally this trading produces relatively reliable price gains.

The most recent change to the S&P/ASX 200 index was in December 2019, when infant formula maker Bellamy’s Australia was removed, having been taken over by China Mengniu Dairy, and replaced by payments technology company EMP Payments; before that, in August 2019, DuluxGroup was removed, having been taken over by Nippon Paint, and replaced by medical imaging technology company Pro Medicus.

In May 2020, global index provider MSCI announced changes to its main MSCI Australia ‘country’ index, under which Alumina, Bendigo & Adelaide Bank, Boral, Challenger, Flight Centre, Harvey Norman, Incitec Pivot and Worley were removed, and Afterpay and gold mining pair Evolution Mining and Northern Star included. That change triggered large share sales, with 10 per cent of some of the affected companies changing hands on the final day before the changes took effect.

Capitalising on turnaround situations

The sharemarket is hard on a poorly performing stock, which usually means the company is in difficult straits. Later, when the company has a new management team, has cleaned up its balance sheet and is back with a plan for business growth, the sharemarket may still be ignoring it. This situation is one in which an astute buyer can make a lucrative investment if they know what they’re doing. Investors who follow market fundamentals can benefit from these turnarounds.

Being a contrarian investor

Contrarian investing is buying when buying seems absolutely the wrong thing to do and selling when exuberance reigns. Psychologically, a contrarian investor is going against the herd instinct, which requires considerable self-belief. However, as we now know, selling all your technology shares in March 2000, or buying back into the battered blue chips in March 2009, or buying back into the market in March 2020, was a very wise thing to do. It just took a lot of guts at the time!

Contrarian investors can make huge gains if they’re brave and patient. Contrarians have great faith in their process of share assessment. However, as the fund manager John Neff says: ‘Don’t bask in the warmth of just being different. There is a thin line between being a contrarian and being just plain stubborn. At times, the crowd is right. Eventually, you have to be right on fundamentals to be rewarded.’

Watching for insider activity

When individual board members buy or sell shares in their company, investors watch carefully. Naturally, shareholders are happier when board members buy rather than sell shares. In fairness, directors should be allowed to raise cash by selling shares without setting off the market. If directors change their shareholdings, this news has to be announced on the stock exchange but not on the actual day of the transaction; these changes are listed as notices of record. Investors watch the transactions of insiders in the hope of detecting a trend; investors want to know whether a transaction is a one-off or whether a flurry of buying or selling is about to occur.

Taxing Considerations

Letting tax considerations drive investment decisions is always a bad move. Whether you’re buying or selling shares, your main objective is to buy future growth. If you concentrate only on gaining a tax advantage, you may lose out in the long term. By all means consult an accountant about your tax liabilities in buying and selling shares, but don’t make your decisions based on tax advice solely.

Minimising capital gains tax

Some people decide not to sell profitable shares because they don’t want to trigger a capital gains tax (CGT) liability. You can’t avoid this tax unless the shares you sell were bought before the law was introduced (19 September 1985). Nothing can protect capital gains from a sudden change in market sentiment, which can turn a gain into a capital loss very quickly.

Selling to take a tax loss

May and June are known as the tax-related selling season. At this time, investors may bite the bullet on shares they’re holding at a loss. If they choose, they can take the loss and offset it against capital gains earned in that tax year, or carry the loss forward for future use. Then, if they want to stay with the shares, they can buy them again at the current price.

Offsetting your annual tax with a capital loss is a perfectly legal deduction. However, CGT can be a problem if it overwhelms your investment strategy. Financial advisers always warn against such decisions. (See Chapter 10 for a guide to tax and shares.)