At the very basic level, investing is either you lending money or taking a stake in a business. As simple as that!
Imagine a friend setting up a new business, say a restaurant. He asks you to invest in his venture. He gives you two options –
- either you can loan him some money, which he promises he will return some specific day in the future, and pay you interest on, or
- you can become a ‘silent partner’. He will be the managing partner, running the business on a day-to-day basis. You take risk to get a share of the upside; there is no interest or promised return; you gain if the business becomes more valuable and lose if it becomes less valuable; there is no automatic return of capital.
If you choose the first option i.e. lend him the money, you are investing in debt. If you choose the second option, you are investing in equity.
You can divide these into further two –
- Debt can be short term (if you lend for less than 12mths) so called cash or long term (more than 12mths) and called fixed interest where you get an annual interest rate
- Equity usually an interest into a business, but can also be into a property; when you invest in property or real estate, you get a stable rent (similar to fixed interest though the tenant can default) and some capital upside (similar to equity)
These categories are called asset classes. Asset classes refer to a group of financial investments that are similar. You could invest in a 10-year government bond issued today, and another issued in a few months’ time. Since both are governments bond that are similar, they would belong to the same asset class – fixed interest.
Or you could invest in shares of Microsoft and those of Apple; again since both are shares listed on a stock exchange, they would belong to the same asset class – equities or shares.
You can divide asset classes into further categories based on –
- risk including real risks such as credit risk or business risk, or market risks (fixed interest could be divided into government debt, investment grade corporate debt, high yield debt, equities could be divided into large cap and small cap etc
- geography could be global, regional, country-specific (equities could be divided into domestic equities, international equities, emerging market equities etc),
- liquidity (equities can be divided into listed equities, private equity),
- focus could be broad-based or sector-specific (equities could be divided into large cap and small cap etc, or into industrials, resources, REITs etc)
We will come back to asset classes later. Let’s get back to your friend’s restaurant business. Think about what questions you would ask him to help you decide whether to invest or not.
Debt and equity require different focus
The first thing that comes to mind is the potential for the business. What kind of food? Aimed at what segment and pricing? Location? How will he find a good chef? How will he do the marketing? Does he need licenses? I am sure you can think of many more questions like this.
Now dig deeper if you decide to lend to him rather than take a stake? You would want to know what interest he would pay you, and how he will make enough revenue to cover your interest payment. Most importantly, how will he pay the capital back? Is he buying an asset with your money that you can take as security? Or can he give you something else as security? You then have to weigh up the security of your capital with the interest he has offered.
On the other hand, if you decide to become a silent partner, the focus of your questions might become more future-oriented. In addition to the earlier questions, you may want to know how much profit the business will make after paying staff, rent, and the interest on any loans he might have taken. You might ask him whether he intends to pay out dividends or re-invest in the business, for example in new locations. After you are convinced about the business potential, you may want to know how much stake you would get.
You are starting to get an idea of what investing is about, right?
Now replace the restaurant with a much larger business. Say something like Apple or Microsoft. The larger the business, the more moving parts there are, but the basics remain the same. You still want to know the potential for the business.
Say you decided to become take a stake for the long term. However, a couple of years later, you need the money for something else. You can’t just demand your money back – it wasn’t a loan.
So how do you get your money? You can decide to sell your stake to somebody else.
The potential buyer will have the same questions as you had, regarding the potential of the business. Since it has been going for a while now, the teething issues are sorted and it now has stable cash flow. But then there’s a competitor that’s opened up next door. So the buyer still has to figure out the future potential, and accordingly offer you a price.
Somebody else might come to you and offer a higher price. He knows the chef and believes the restaurant will do well in spite of the new competitor.
Yet another person may come to you and make an even higher offer because he wants to merge the restaurant with his restaurant chain. He thinks he will be able to lower costs by combining overheads.
So you see that people will offer you different prices based on their outlook for the restaurant industry and that particular restaurant.
The different people coming to make you different offers on your stake in a business are collectively known as the ‘market’. It’s no different to the market for anything else – think of the vegetable or fish market. A grower may stand with his produce and different people will offer different prices to buy his produce.
To make the process of bidding easier, somebody might up a notice board on which the grower could put his asking price. Potential buyers might put up their offer price. The grower might then accept the highest offer.
The stock exchange is basically such a notice board. It just reflects the various bids and offers on all the companies’ equity components – and the people bidding make up the market.
There is a separate bond market for the debt component of the companies, which works on the same principles.
So the market reflects all the bids for all the companies listed on the stock exchange. The last price on which the stock traded is considered the market price i.e. the price at which a willing buyer and willing seller were willing to transact.
When the market price of a lot of the stocks goes up, the ‘market’ is said to be going up. And when the market price of the majority of them go down, the market is said to be going down.
To capture these movements, some people come up with an index; it’s a hypothetical basket of one share from each company. So when market price of these shares go up or down, the index reflects that.
Note the market is there just to tell you what you could get in case you want to sell your stake. You don’t actually have to sell at that price. You could wait until the prices are higher (unless of course you were wrong to have paid that much to start with but we will discuss that later).
So to summarise, there are two ways you can invest. You can either lend money, which is called investing in debt. Or you can take a stake in a business (or a property).
You will need to assess the potential for that business. If you are lending, the focus will be on what assets are offered as security, and whether the interest rate is enough to compensate you for the risk that the business doesn’t pay your interest on time or doesn’t return the capital in full on the due date. If you are taking an equity stake, you will need to focus more on the future potential of the business.
Then you have to work out what price you want to pay for it, or at what price you want to sell it.
Irrespective of what you think the value of the business, and therefore your stake is, there will be other people in the market who might have a different opinion. These people might have different information or insights into the business or different valuation tools that make them think the value is different. Hence, they make different offers for the equity in a business on the stock exchange. These bids make the market go up or down on a daily basis.
That was easy enough, wasn’t it?
In the next few posts, I will add some jargon to this basic concept so you become familiar with them. Like it or not, you will come across them in real life. But remember that if you don’t understand something, ask your adviser to explain it in the context of this basic chapter – are you lending or taking a stake? What’s the risk or future potential? What does the market think about your stake?