Book summary “How the stock market works”: summary

Introduction

You want to grow your wealth through the stock market, but complex terminology and volatile prices make you hesitate. Without a clear grasp of financial assets and valuation methods, you risk losing capital to poor decisions and market manias.

Michael Becket explains how the market works by breaking down the mechanics of shares, bonds, funds, and derivatives. You learn how to read company accounts, calculate vital financial ratios, and manage your trading risks. The book equips you to navigate exchanges with confidence and discipline.

• How do you buy and sell shares through a stockbroker?
• What separates a sound investment from a speculative bubble?
• Which ratios reveal the true financial health of a company?
• How do you protect your portfolio against sudden market crashes?

1. Understanding Shares and Bonds

Entrepreneurs raise initial money from savings, friends, family, banks, and venture capitalists. They issue shares as receipts of part-ownership. You become a part-owner of a business rather than a lender when you buy these shares.

Purchasing shares makes you a part-owner of a business with ownership privileges, while bonds represent tradable debt issues providing fixed interest returns.

Shares and Ownership

Owning shares grants you specific ownership privileges like appointing the board and receiving dividends. Shareholders are entitled to dividends depending on profits. You can also achieve capital appreciation when the share price rises.

Corporate shareholders face different legal conditions than traditional partners. Unlike partnership owners who hold unlimited personal liability, corporate shareholders cannot lose more money than they spent to buy the shares. This limit protects you from creditors if the company goes broke.

Imagine a company with 100,000 shares total. If you own 10,000 shares, you hold a tenth of the business.

Historical returns show long-term gains for equity holders. US shares returned 10 per cent per annum between 1904 and 2004. UK shares returned 8.5 per cent between 1904 and 2004.

Bonds and Gilts

Bonds are tradable long-term debt issues. An issuer promises to pay regular interest and repay the principal on a redemption date. Corporate bonds pay a fixed interest rate known as the coupon, regardless of whether the company makes a profit.

Different debt instruments carry varying levels of security and risk:

• Debentures are bonds secured against company assets, allowing holders to appoint a receiver if the company defaults.
• Unsecured loan stocks pay higher interest to offset higher risk.
• Permanent interest-bearing shares, known as Pibs, offer alternative income yields.

British government bonds, known as gilts or gilt-edged securities, are considered effectively risk-free. British government bonds have never defaulted on interest or principal repayments. The state issues them to cover the Public Sector Borrowing Requirement, grouping them into shorts, mediums, and longs based on their maturity dates. The nominal face value of a gilt or security used as par value is 100p.

Chinese governments, Tsarist Russia, US states, and Latin American enterprises issued beautifully engraved bonds that were never redeemed and are now used as lampshades or lavatory decorations.

2. Pooled Investments and Derivatives

Pooled investment vehicles spread your risk across many companies and place management in the hands of professionals. You can choose from several collective investment schemes depending on your risk appetite and objectives.

Pooled investment vehicles spread your risk across multiple companies, whereas derivatives and contracts for difference offer leveraged exposure for hedging or speculation.

Investment trusts are closed-end funds with a fixed number of shares quoted on the stock exchange. Their share price can trade at a discount or premium to their underlying asset value. Unit trusts are open-ended funds where you deal directly with the management company at buy and sell prices reflecting the value of underlying shares. Exchange traded funds are baskets of securities that track an index, trade on the stock exchange like shares, and feature low administration costs with an annual management fee ceiling typically found at 0.5 per cent.

Blindfolded staff at a US business magazine threw darts at the price pages of the Wall Street Journal and found their selection beat every major fund manager.

You can build a steady position by following a disciplined accumulation strategy:

• Decide on a set regular investment amount.
• Contribute funds periodically regardless of market peaks to lower the average purchase cost through pound cost averaging.

Derivatives and CFDs

Derivatives are high-gear financial instruments derived from underlying assets used either for risk hedging or speculative bets. Their risks can exceed your initial investment. Futures and forwards are contracts to buy or sell an asset on a future date at a specified price. They require only a small margin deposit that heavily gears potential gains and losses, with a 10 per cent standard margin cost required to purchase a futures contract.

Options grant the right, but not the obligation, to buy via a call option or sell via a put option at a strike price before an expiry date. Your losses are limited to the option premium paid. Swaps involve exchanging cash flows based on underlying interest rates or currencies.

American International Group had to be recapitalized with $85 billion of debt provided by the US federal government after losing more than $18 billion on credit default swaps. Orange County in California was bankrupted in 1994 by losing $1.6 billion in derivatives trading.

Contracts for difference mirror asset trading without requiring ownership of the underlying security. They allow you to take long or short leveraged positions by paying the difference in price of an asset over a stated period without any underlying shares changing hands. You must maintain a margin percentage set by the broker or market-maker ranging from 1 to 30 per cent of the notional value of leading equities. A 5 per cent margin requires an initial deposit of £175 to buy 1,000 shares priced at 350p each.

Long positions incur daily financing charges tied to benchmark interest rates like LIBOR. Because no equities change hands, they are exempt from stamp duty. Losses can exceed your initial margin deposit unless mitigated with stop-loss orders.

A group of hedge funds linked to BAE Systems acquired more than 15 per cent of Alvis through CFDs without having to warn the regulator.

You can manage your positions by executing these steps:

• Calculate the notional value of the desired leading equities position.
• Deposit the required margin percentage ranging from 1 to 30 per cent with the brokerage or market-maker.
• Set a stop-loss order at a predetermined price point to automatically trigger an exit if the market moves against the position.

3. Strategy and Fundamental Analysis

Stock market investing should only be done with spare cash after securing essential needs. Before putting money into riskier stock market investments, you must grade your safety and access to spare cash.

This includes maintaining a current account for daily expenses and accumulating funds for predictable large expenditures. You must also set aside provisions for a safe old age, life assurance, pensions, and rainy-day reserves.

Successful investing requires setting clear financial goals, utilizing fundamental analysis to evaluate company accounts, and ignoring market manias.

Screening potential investments requires setting clear goals rather than simply aiming to make money. You must decide the acceptable amount of risk compared to safe alternatives like gilts and establish a short, medium, or long-term time horizon. You also need to choose between high-yield income companies or low-dividend capital growth companies.

Because companies are subject to economic vagaries while alternatives like index-linked gilts are guaranteed, equities typically yield several percentage points higher than government bonds and deposit accounts. This extra compensation is known as the equity-risk premium. Since the end of the Second World War, equities have beaten the inflation rate by 7 per cent or more. Shares in Britain have provided an average return of 12.2 per cent a year since 1918. Government gilt-edged securities have produced an average return of 6.1 per cent since 1918. Cash in a deposit account has produced 5.5 per cent.

Setting Investment Goals

Different experts recommend contrasting selection rules:

• Go for funds or sectors near the bottom of the league tables.
• Go for shares with high yields, but if they survive that long, sell in a year.
• Watch what directors do with their shares.
• Buy companies where at least 3 per cent of the shares are owned by the workforce.
• Companies spending over 4 per cent of turnover on research tend to do well.
• Buy after a profit warning if the company is fundamentally sound but going through an unlucky patch.

The random walk theory asserts that price movements are unpredictable and wins or losses are pure chance. The efficient market hypothesis claims share prices fully reflect all available knowledge, making it impossible to consistently outperform the average. However, some famous investment managers have performed 5 to six times better than the market as a whole over a long term. Frequent market overreactions, hysteria, and the success of long-term professional investors show the market is not entirely rational or efficient.

Evaluating Businesses

Fundamental analysis involves evaluating a business, its accounts, and economic factors to find mispriced shares. Assuming the stock market is reasonably efficient rather than perfectly efficient, a shrewd analyst can calculate the true value of a business and spot companies or sectors that are temporarily out of favour. This process evaluates the business and products, examines published accounts and return on capital, estimates earnings and dividend prospects, reviews the economic ambience, watches competitors, and judges management.

Market history is punctuated by speculative manias where greed and hope override common sense, causing share prices to reach unsustainable levels before an exaggerated downward correction occurs. Examples of historic market manias include the South Sea bubble in the 18th century, the railway mania in the 1830s, and the dotcom lunacy in 1999 when share prices doubled every weeks and unknown web-based companies became worth hundreds of millions. A dotcom share price rose from 230p to £87 in less than a year during the 1998-99 bubble.

Investing in foreign shares offers global opportunities but introduces added risks including foreign economic shifts, sector regulations, local market peculiarities, and currency exchange rate fluctuations. A substantial number of foreign companies from Europe, the US, Asia, and other regions are quoted on the London Stock Exchange, and online brokers make direct overseas trading increasingly accessible. However, you face exchange rate risks where a trading profit can be wiped out by the relative movement of sterling, as well as variable recording and ownership controls in emerging markets. For novices, buying investment trusts or unit trusts with an overseas profile or investing in UK companies with heavy international trade eliminates foreign exchange considerations and spreads risk.

Swiss shares commonly cost £5,000 each, with some exceeding £20,000 for a single share, creating a higher barrier to entry for small investors.

You can manage overseas investments by executing these steps:

• Check in advance whether your UK broker offers the service of buying overseas shares directly.
• Research the target country's economic status, impending interest rate changes, and sector trade agreements.
• Select investment or unit trusts with an overseas profile to delegate stock selection to professionals and eliminate foreign exchange risk.

4. Financial Ratios and Valuation

Market purists divide asset assessment into fundamental and technical approaches. Fundamental analysis requires examining a company's product quality, management competence, financial condition, customer base, and economic environment. Technical analysis, or chartism, ignores underlying business worth entirely and focuses solely on recent share price patterns to forecast future shifts.

Financial ratios such as the price/earnings ratio, acid test, gearing, and dividend cover allow you to measure company solvency, profitability, and risk.

Key Financial Metrics

The price/earnings ratio measures how many years of current earnings it would take to equal a company's total market value. A high P/E ratio typically reflects investor expectations of rapid future growth rather than literal payback time. You must compare a company's P/E against the broader market index and sector peers to assess relative risk and market sentiment.

If Windowledge Holdings International issues 70 million shares, makes an £8.4 million profit resulting in 12p earnings per share, and maintains a 390p share price, its historic P/E ratio is 32.5.

To evaluate P/E ratios and valuations, you can follow these steps:

• Find the earnings per share from the company accounts.
• Divide the prevailing market price by the earnings per share to get the P/E ratio.
• Compare the P/E ratio with other companies in the same industry sector.

Dividend cover indicates the safety of a company's dividend payments by showing how many times net profits encompass the distributed sum. A high cover ratio demonstrates that a company is retaining sufficient earnings rather than straining its finances to pay shareholders. Ratios below 1 indicate that a company must dip into accumulated surpluses from previous years to maintain dividend payouts.

If Windowledge plc pays a 4p dividend per share while reporting earnings per share of 12p, its dividend cover is a cautious 3 times.

Net asset value calculates the underlying worth of a business per share if all assets were liquidated and liabilities settled. NAV establishes a baseline for judging investment trusts or identifying potential takeover targets.

To calculate net asset value, you must execute these steps:

• Add up the book value of all company assets including buildings, machinery, cash, and investments.
• Deduct all liabilities such as unpaid bills and borrowings, plus capital charges like debentures and preference shares.
• Divide the remaining shareholders equity by the number of ordinary shares in issue.

Return on capital employed evaluates how efficiently a company utilizes its long-term cash to generate operating profits. This metric helps you determine whether a business venture delivers an adequate risk premium over safe investments like gilts.

To measure this return, you can follow these actions:

• Take the trading profit before exceptional items, interest, and tax.
• Divide by the average capital employed over the period, consisting of shareholders funds plus borrowings.
• Multiply the resulting figure by 100.

Assessing Risk

The acid test ratio measures a company's short-term solvency by comparing its most liquid assets against current liabilities. The acid test provides a realistic view of immediate debt-paying ability without relying on the liquidation of slow-moving inventory or work in progress.

To assess short-term solvency, you should complete these tasks:

• Take current assets minus stocks to find net monetary assets.
• Divide net monetary assets by current liabilities.
• Check that the result is safely around 2, as a result under 1 indicates a precarious balance.

Gearing measures the proportion of a company's borrowed money relative to shareholder equity, highlighting vulnerability during economic downturns. High gearing magnifies risks because interest payments on loans must be met regardless of business conditions, unlike dividends which can be passed.

To check leverage, you need to use these calculations:

• Take the total borrowings of the company.
• Compare the total borrowings figure with the total amount of shareholders funds or equity.

Beta measures an individual share's price volatility relative to the broader stock market to gauge risk and expected return. Unlike accounting-based metrics, beta evaluates how much a specific share price moves when the overall market changes. A market beta is set at 1, while higher positive betas indicate greater sensitivity to market booms and slumps.

The Altman Z-Score is a specialized calculation designed to predict the probability of corporate bankruptcy within a two-year window. Edward Altman studied 66 manufacturing companies with assets over $1 million, half of which had gone bust, and found his test predicted 72 percent of corporate bankruptcies two years prior to occurrence.

To calculate the Altman Z-Score, you apply these formulas:

• Calculate working capital divided by total assets and multiply by 1.2.
• Calculate retained earnings divided by total assets and multiply by 1.4.
• Calculate earnings before interest and taxes divided by total assets and multiply by 3.3.
• Calculate market capitalization divided by total liabilities and multiply by 0.6.
• Calculate net sales divided by total assets and multiply by 0.999.
• Add the weighted results to produce a final Z-score between -4 and +8.

5. Trading Costs and Risk Management

Minimizing transaction costs, diversifying portfolios, avoiding boiler room scams, and cutting losses early protect your capital from severe depletion.

Trading Costs

Stockbrokers charge minimum fees on transactions, and small company shares often have wide price spreads. These combined costs mean a small parcel of shares must rise significantly just for you to break even, stacking the odds against you. Many advisers recommend £2,000 to £3,000 as the smallest sensible amount for a single investment.

If a dealing cost is £20 for a £500 parcel, the share must rise by over 8 percent just to break even, not counting the buying and selling spread.

Trading shares involves multiple fees including broker commissions, registry charges, and government stamp duty. You can evaluate broker charges, internet services, and special offers through online comparison sites.

Risks and Frauds

Amateur investors often make the mistake of holding onto losing shares out of sentiment, whereas professionals cut losses early. Unlike professionals who use stop-loss signals to automatically drop falling stocks, small-time investors often display a sentimental attachment to bombed-out companies or refuse to admit a mistake. Some mistakenly engage in averaging down by buying more shares at lower prices, risking further losses.

• Establish an action point where a stop-loss signal is triggered by a fall of 10 to 15 per cent.

To reduce risks associated with corporate incompetence or external shocks, you should diversify holdings across multiple companies. A decent portfolio should contain a minimum of 10 companies even for a relatively small investor.

Uninvited cold calls and fraudulent boiler rooms cost investors hundreds of millions annually through high-pressure advance fee scams. Fraudsters operating bogus brokerages use sophisticated tactics, fake websites, and well-spoken persistence to trick investors into buying worthless shares or paying advance fees. Victims often lose substantial sums, and because these operations are usually based overseas, you have little legal recourse.

The City of London Police recorded an individual maximum loss of £1.2 million to boiler room scams, with 41 percent of victims having invested for over 11 years.

• Hang up immediately on uninvited phone calls trying to sell shares or investments.
• Do not respond to emails or messages asking for personal information or money purporting to come from the FCA, Bank of England, or Ombudsman.
• Check the official FCA website to verify if a firm is properly authorized.
• Forward suspicious information or scam attempts to Action Fraud or the police.

10 Key Ideas

1. Purchasing shares makes you a part-owner of a business with ownership privileges, while bonds represent tradable debt issues providing fixed interest returns.
2. Pooled investment vehicles spread your risk across multiple companies, whereas derivatives and contracts for difference offer leveraged exposure for hedging or speculation.
3. Successful investing requires setting clear financial goals, utilizing fundamental analysis to evaluate company accounts, and ignoring market manias.
4. Financial ratios such as the price/earnings ratio, acid test, gearing, and dividend cover allow you to measure company solvency, profitability, and risk.
5. Minimizing transaction costs, diversifying portfolios, avoiding boiler room scams, and cutting losses early protect your capital from severe depletion.
6. Corporate shareholders enjoy limited liability protecting them from personal financial ruin if the company goes bankrupt, unlike traditional business partners.
7. Equities historically outperform government bonds and cash deposits over long periods, compensating investors with an equity-risk premium for bearing higher volatility.
8. Fundamental analysis evaluates a business, its accounts, and economic factors to find mispriced shares, assuming the market is reasonably efficient rather than perfectly efficient.
9. Financial metrics like the Altman Z-Score and beta help investors quantitatively assess corporate bankruptcy probability and asset price volatility relative to the broader market.
10. Retail investors should avoid sentimental attachments to losing stocks, maintain portfolio diversification across at least ten companies, and hang up immediately on uninvited boiler room cold calls.