Ways of Earning from Stocks
There are a number of ways of making money out of your stock investments. We discuss the principal ones in here.
- 1. Price increase—when the price of the stock rises you have what is called Capital appreciation. When you buy a stock at a certain price and then it appreciates in value you have just increased you wealth. Over the last few years the Zimbabwe Stock Exchange was one of the best performing exchanges. I believe that right now most of the stocks on the ZSE are undervalued and so as the economic fundamentals change one is likely to see a revaluation of stocks to give great wealthy returns to patient investors. An investor with a long term view generally benefits from the long term growth of stocks.
- 2. Paying dividends—These happen when the company shares its profits with investors through payments of a certain dollar value per share owned. If one is investing for cashflow purposes on the stock then it is important to understand the dividend policy of the company. Some companies rarely declare dividends. For example within the first ten years Econet never declared a dividend but now declares dividends regularly. I know an unlisted company which is doing well but has never declared a dividend in its fifteen year history. In terms of earning wealth from dividends one needs to own a huge chunk of shares of the company for the dividend to be meaningful. This means therefore that when one has Strive Masiiwa’s shareholding in Econet about 80% his dividend payout if effected at the declared dividend level would translate into about USD8 million. NB. While you earn dividends when you own stocks, you earn capital gains when you sell them. You earn a capital gain if you sell a stock for more than its basis. The capital gain attracts capital gains taxes.
- 3. Trading shares – this happens through buying and selling. The person who does this has to be an astute investor who understands trends etc. S o this person will purchase a stock at a lower price hold it for a short while and then when the price hikes, they dispose and get their profit. By repeating this process numerous times one makes significant wealth. I should warn against novices doing this as they tend to be burnt. In 2000 an acquaintance heard about this type of income generation and he played the market a while and made significant returns. Out of both greed and excitement, he sold his residential property and invested the money on the stock exchange. His intention was to make a quick buck and then turn around and buy a bigger and better house. Unfortunately he mistimed the market and lost big time. He lost his initial capital as the counters he had targeted failed to perform. At the same time the prices of property hiked and so he could not afford to buy a house from his proceeds. He committed two fundamental errors namely 1. Trying to time the market and 2. Investing money he could not afford to lose. Trading shares is highly speculative and therefore high risk. I caution that only experts should work at this. A note of caution I do not recommend borrowing money to trade in stocks. This is pretty dangerous to your wealth creation mechanism unless you are an accomplished investor who can insure your investments.
- 4. Use the shares as collateral for loans. This is a prudent approach if you can get a good banker who will accept the shares as collateral. It is prudent because you do not want to sell an asset to acquire an asset because in most cases there will be no effective change in your balance sheet. At the height of hyperinflation a friend and myself leveraged our Econet stocks to borrow funds from a building society and then invested the funds into more Econet shares. Because of the relationship I had with my broker we bought the shares with no money down and in the meanwhile we converted the Zimbabwe cash into USD because the rate was escalating by the day. At the seven day payment time we reconverted a portion of the USD and pay off the broker. At that time we had already derived value because the price had risen markedly for the Econet shares. At the proper time we disposed the balance of USD holdings and paid off the bank. This was we used existing shares as collateral to acquire more wealth.
- 5. Short selling In short selling, the investor borrows stock (usually from his brokerage which holds its clients’ shares or its own shares on account to lend to short sellers) then sells it on the market, hoping for the price to fall. The trader eventually buys back the stock, making money if the price fell in the meantime and losing money if it rose. Exiting a short position by buying back the stock is called “covering a short position.” This strategy may also be used by unscrupulous traders in illiquid or thinly traded markets to artificially lower the price of a stock. Hence most markets either prevent short selling or place restrictions on when and how a short sale can occur.
- 6. Margin buying
In margin buying, the investor borrows money (at interest) to buy a stock and hopes for it to rise. Most industrialized countries have regulations that require that if the borrowing is based on collateral from other stocks the trader owns outright, it can be a maximum of a certain percentage of those other stocks’ value. A margin call is made if the total value of the investor’s account cannot support the loss of the trade. Upon a decline in the value of the margined securities additional funds may be required to maintain the account’s equity, and with or without notice the margined security or any others within the account may be sold by the brokerage to protect its loan position. The investor is responsible for any shortfall following such forced sales.
Regulation of margin requirements by the Federal Reserve in USA was implemented after the 1929 crash. Before that, speculators typically only needed to put up as little as 10 percent (or even less) of the total investment represented by the stocks purchased. Other rules may include the prohibition of free-riding: putting in an order to buy stocks without paying initially (there is normally a three-day grace period for delivery of the stock), but then selling them (before the three-days are up) and using part of the proceeds to make the original payment (assuming that the value of the stocks has not declined in the interim).
Extreme Caution: If you are a novice do not try methods 5 and 6 of earning from stock investing. I include them here for completeness of discussion only. I am not sure at this stage if these forms are legal in Zimbabwe. In a number of markets worldwide these are not legal either.