Capital markets are one of the major engines driving the world economy today. Yet most of us do not understand what goes on there. Starting from this month, New African will publish a regular, monthly column exclusively on the capital markets, explaining how they work. The objective is to encourage our readers, especially the Africans, to take more interest in capital markets. In this opener, Paul Osei-Kuffour, an expert on capital markets, takes us through the ABCs of equity investment.

Every investor has a reason for making an investment decision. He or she wants to get one or all of the following from his or her investment:
- highest expected returns;
- achieving a return in excess of inflation;
- immediate access to his or her funds at all times;
- certainty, for example, earning a guaranteed 10% per annum return.

It is not easy to suggest which of the above-mentioned expectations is the most important. It will depend on the precise circumstances of the particular investor. Moreover, the fundamental investment objectives should aim to find an appropriate balance between risk and reward.

Reward can be defined as the variance (or the standard deviation) of the return. Thus an investment with a highly uncertain level of return is classified as risky.

The main types of investments include:
- Cash and money market instruments;
- Government fixed interest bonds (gilts);
- Corporate fixed interest bonds;
- Index-linked gilts (UK);
- Property;
- Equity.

The term equities simply means "shares" in the ownership of companies. Equity share capital is the ultimate risk-bearing capital of a company. Strictly, equities include all the different types of shares that might exist, that is, ordinary shares, preference shares, deferred shares, etc. However, the most important categories are ordinary shares and preference shares.

Quoted shares are those with prices that are quoted on any stock exchange. Unquoted shares have different characteristics. The full description of the shares will be found in the "memorandum" and "articles" of association of the company.

The "memorandum of association" states the share capital with which the company is established and the number and size of these shares.

The "articles of association" states the various rights of the shareholders, the ancillary rights attached to these shares (which include receiving notice of meetings and the company's annual reports and accounts), and duties attached to holding shares (for example, paying what is due when payment is due and the requirements to inform the company if more than 5% of any class of the stock is held, etc.

What do you get as an investor? 1. Income: The investor gets a share in the distributed profits (called "dividends") of the company. The company's profits will hopefully rise with inflation, real economic growth and advances made by the company. This implies that dividends too must rise, but there is no guarantee. However, during periods of recession dividends may fall.

Companies do not guarantee the future level of dividends, or indeed, whether any dividends will be paid at all. As most shares are of indefinite term, the dividend stream is indefinite. Shareholders will continue to be entitled to dividends for as long as they own the shares, and the company continues to exist. 2. Capital: Shareholders hold their shares with a view to benefiting from capital appreciation. However, the value of a particular share is whatever that share is worth on sale. There is no guarantee.

The income stream from shares in large, well-managed companies is generally considered to be quite secure. However, during the recession of 1990-92 in Britain, a large number of UK companies cut their dividend payments.

It is important to know that income from equities is less secure than the interest payments on corporate debt. The reason is that fixed interest payments have a higher priority than dividends to shareholders. Nevertheless, the security will vary considerably from company to company.

Thus, the security of income from equities is mainly dependent on the strength and stability of the companies' future profits and the level of "dividend cover". Dividend cover is the inverse of the payout ratio, that is, the proportion of profits which are paid out as dividends. The lower the payout ratio, the higher the security.

Which takes us to the next important item, security of capital. Ordinary shares are often referred to as equity capital. They are irredeemable and if the company is unsuccessful, the loss is limited to the nominal value of the share. If the company is wound up, the shareholders will receive the residual assets after all creditors have been paid. Thus, in the event of liquidation, debt holders, preference shareholders, and all of the company's creditors will rank above the ordinary shareholders.

Marketability of equities varies enormously. Shares in the largest UK companies, for example, are highly marketable. Many other shares have reasonable marketability. However, shares in smaller companies have poor marketability.

Investment in unmarketable shares should therefore be seen as part of a long term investment strategy. Lack of marketability therefore restricts the potential for profits from active trading.

The market value (or price) of individual shares is determined by the interaction of supply and demand within the market. Market values can be very volatile. The more volatile the share price, the less secure the capital value of the investment, and vice versa.

There are four main levels at which the prices of particular shares may be influenced:

1. Movement of the worldwide equity markets. The whole market moves up or down in response to global news or views. A good example is the week of what the British call "Black Monday" in October 1987 when the market as a whole lost about one-third of its value. Similarly, the movements of the Dow Jones Industrial Index (US) have considerable impact on the direction of other major stock market indices around the world.

2. Overall market movement in a particular country which may be caused by the following factors:

(a) Political upheavals, for example, a surprise general election result (as John Major's Conservative Party won against the odds in April 1992 in the British general elections).
(b) Changes in tax rates in the budget.
(c) Announcements of wars or ending of hostilities, for example, the Falklands and Gulf Wars.
(d) Changes in outlook for inflation.
(e) Devaluation of currency.
(f) Trade figures, money supply or unemployment levels being different from those forecast.

3. News about a particular industrial group affects the share price of companies in that industry. An example is the period when all companies in a sector report good or bad results.

4. News about a particular company. This may include the following:

It can be seen from the above analysis that some shares (such as oil exploration) are more volatile than shares in other industries (such as food retailing).

To buy or sell shares, you must use a stockbroker, or the stockbroking division of a bank or building society. If an investor is prepared to pay an annual fee for a discretionary service, the broker will buy and sell on his or her behalf.

On the other hand, the less well-off investor must use an execution-only service, where no guidance is provided.

The investor can "deal" (buy or sell) either by post, by phone or via the internet. He or she pays a commission to the stockbroker (in the UK, a minimum of about £15 depending on the type of service provided). He or she will also pay a stamp duty (0.5% in the UK, for example) to the government.

The dividends are paid net of tax, and investors in the UK (for example) receive a tax credit based on 20%. Higher rate (40%) tax payers must pay additional tax. Basic rate (25%) tax payers and companies will keep the net dividend with no further tax.

Equities are perceived to be more risky than debt securities, and would be expected to give higher returns to compensate. However, the extent of risk depends on individual shares. Shares in a company with a solid profit stream are low risk unless they are massively overpriced.

The most compelling argument for investing in a spread of shares is that, over the long term, they have the potential to appreciate. It is said that between 1945 and 1998, £1,000 invested in shares in Britain grew to £83,284 whilst an equivalent amount deposited in a building society grew to just £1,326. This explains why pension fund companies put the bulk of your contributions in the stock market. Thus equities are a "real" investment. They provide a hedge against inflation.

In practice, most investors would buy shares in a well diversified range of companies. This reduces the risks attached to equity investment. Thus the investor can reduce the risk of losing money in equity investment by carefully researching companies in order to minimise the danger of walking into an over-priced glamour stock which has fundamental problems. A very good example is Asil Nadir's UK Polly Peck Company.

Investors can also reduce the risk of a large drop in the capital value of their equity portfolio by selecting shares which have little correlation in their performance.

Finally an investor who is not good at making decisions can enter the stock market via an investment or unit trust which holds a variety of shares. Alternatively, UK investors can wrap their trust holdings in an Individual Savings Account (ISA). This would allow you to escape tax on most of the income.