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Equities: stocks and shares

In the UK we call them ordinary shares, in the US they talk about common stock, and in finance we refer to equities. They all mean the same thing. The ordinary shareholders in a company are the owners of the business. The company may well owe money to the bank. It might have preference shareholders who are entitled to receive their dividends and their share capital repaid in preference to the ordinary shareholders. But what is left after paying all the others to whom the company owes any money belongs to the ordinary shareholders, and that residual value is ‘the equity’ of the company. It is sometimes referred to as risk capital because the money the shareholders originally put into the business is the riskiest. There isn't any guarantee of any income and the capital can’t normally be repaid. On the other hand, if the business is successful all that it makes after paying off what it owes is available to the shareholders.

Private companies

When a business is incorporated as a limited company, it issues shares for cash or money’s worth to the original shareholders. Very many companies start out as simple family businesses with perhaps just two or three shareholders, who both own and run the business. Many companies never get beyond that stage. They remain private, with just a few close shareholders. However, other companies expand. They might issue more shares for cash to raise money to grow, whilst still remaining private. Being private means that the ordinary shareholders have no way of getting out the money they put in originally unless other existing shareholders are able and willing to buy them out. Even then, because the shares are not listed on any stock market, establishing a fair price is not easy. Shareholders with more than 50% of the shares of a private company can pretty well run the business in any way that suits them. There are few safeguards for minority shareholders (those with less that 50%).

Public companies

Once a company is well established and profitable, it can apply for its shares to be admitted to listing on a stock market. At the Initial Public Offering (IPO or flotation), the company may issue new shares for cash as well effectively putting a price on the existing shares belonging to the founders or current owners. Subsequently, shares in the company can be bought and sold through the market, although the number of shares that can easily be traded can be limited. (You could find it very difficult to buy or sell more than a few percent of the shares in any company simply by calling your local stockbroker). On the whole though, once a company is listed on the Stock Exchange you can buy or sell its shares in a few seconds, and millions of shares are traded every day.

Ownership and management

With most private companies the same people both own and run the business. In the case of public companies, especially large ones, it is unusual for those who manage the business to have significant shareholdings. Many directors do own shares, and others have options to buy shares, but as a rule the proportion of shares that they own will be small. It is also unusual to find individual shareholders with more than a few percent of any large public company, and there can typically be thousands of individual shareholders. Even where you do find institutional investors (pension funds or insurance companies) owning a few percent of the total shares in a company, it is rare for such shareholders to play any kind of active role. Ownership and management are divorced.

Does this matter? In some cases it certainly does. Although directors and senior managers generally like to keep shareholders happy and on-side, they are motivated primarily by self interest (aren't we all?) and that does not always coincide with the interests of the shareholders. For example, where there is a takeover, the shareholders of the company being taken over tend to do better than shareholders in the acquisitive one. Bigger might mean better for the directors but not for their shareholders. Takeovers are macho. They also mean huge fees for merchant bankers, accountants and solicitors. But they don’t necessarily increase shareholder returns, and often reduce them in the long run.

Value measures

There are several valuation measures applied to equities. In general these are accounting numbers obtained from the company’s annual report, which are compared to the share price to provide a crude measure of value. The main ones you will see quoted alongside the closing prices in newspapers such as the Financial Times. These are Price Earnings (PE) ratio and Dividend Yield.

PE ratio

The PE is the share price divided by the Earnings Per Share (EPS). Essentially EPS means the profit that the company has left after paying tax (and allowing for some adjustments) divided by the number of shares that are issued. It’s a measure of how much money the company has earned during the year for the owners of every one of its shares. If the EPS is, say, 10p per share then if I own 100 shares, the company has effectively made £10 for me, on paper at least. Suppose the share price is 200p then the PE is 200 divided by 10, which is 20. The higher the PE, the higher the expected growth rate. A very rough rule of thumb is that you could expect the growth rate in earnings to be about the same as the PE. If a PE is 20, the market might well be expecting the company’s earnings to grow at around 20% a year for the next year or so.

Dividend yield

The yield is the net amount of dividend paid per share during the year divided by the share price. Taking our example above, if the company decided to pay a total dividend for the year of 5p after deducting 10% dividend tax, the yield would be 5p divided by the share price of 200p, which is 2.5%. In the financial pages you would see something like:

XYZ plc 200p PE 20 DY 2.5

Since the PE is 20, we know the earnings must have been 10p per share, we know the dividend must be 5p per share, so the dividend cover (the number of times the dividend could be paid out of earnings) is 2.

Value v. growth

We've talked about growth a good deal, and you may think that companies with high growth rates are the ones to invest in. However, by the time most of us get round to realising that XYZ plc is growing like crazy, the rest of the market is ahead of the game and the share price already reflects the prospects. The PE ratio tends to be the most widely used rule of thumb in share valuation. Companies with high PEs are expected to grow relatively quickly. Those could include technology-based industries and new and exciting retail businesses, especially smaller companies. Those with low PEs are regarded as having little prospect of increasing their profits very much each year. These tend to be larger companies including utilities and traditional manufacturing businesses. The average PE for the companies in the FTSE 100 index is currently 15.7 with the index at 5000. (The average dividend yield is 3.1%).

The range of PEs goes from 0 to 500 but about 40% have PEs below average and 60% above. Similarly, about 40% have yields above average (3.1 to 6.7%) and 60% below (0.4 to 3.1%). Companies with low PEs and high yields are referred to as ‘value’ shares. Unexciting but often cash-generators, paying out a high proportion of their earnings in dividends. The so-called ‘growth’ companies are perceived to have more exciting prospects and that faster growth will more than compensate for lower pay outs. One of the oldest established conundrums in financial economics is why value shares tend to produce higher returns than growth. If markets are truly efficient then any trading rule (such as buy the five shares with the highest yield etc) wouldn't produce consistently better returns than buying at random. However, history shows us that some simple trading rules do pay off, at least quite a lot of the time.

Investment styles and strategies

Successful investors (those that consistently beat the market) tend to have well-defined strategies for selecting shares. For example, the legendary Warren Buffet has made fortunes for himself and his investors by adopting a value-based approach and avoiding technology. However, life is rarely as simple as selecting a few shares with low PEs or high yields. Many pooled investment funds (unit and investment trusts) select shares in particular sectors, or those with above-average yields, or those that are expected to grow faster than average. You often find that certain styles will work better during different market conditions, and that over long periods returns may tend towards the average for the market as a whole.

There are many books that offer insights into various investment styles. We will be discussing this topic in more detail at a later date.

Direct investment v. pooled funds

Pooled funds provide diversity, eliminate the need for you to research companies, and save you the paper work that you have to do if you manage your own equity portfolio. The downside is that there is usually an up-front charge (5% of the amount you propose to invest is typical) when you invest in a unit trust or managed fund, although you may get part of that waived if you invest through a discount broker or some Independent Financial Advisers (IFAs). There will also be an annual management fee of around 1% or more of the value of your investment. These costs are significant, but don’t underestimate how much time you would have to spend if you invest directly.

There is quite a wide variation in performance between managed funds and you need to shop around. You also need to be aware that because a fund has done well in the past you can’t assume it will continue to do well in future. Fund managers move around the industry and certain styles don’t necessarily produce above average returns consistently.

As well as managed funds that aim at maximising income or growth, you also see funds that invest in smaller companies, emerging technologies, overseas markets, etc. Generally these are all actively managed: the fund managers decide asset allocation and individual share selection. Funds that are designed to track an index are referred to as passive: there isn't any skill employed in simply buying all the shares in, say, the FTSE 100. Passive or tracker funds tend to have lower management charges.

Exchange traded funds are essentially index trackers wrapped up as shares. They can be bought and sold through stockbrokers in exactly the same way as any normal share, but their prices always reflect the prices of all the shares in the index concerned. Their holdings of the shares they are tracking are re balanced twice a year. Fund management fees are typically around 0.35% per year.

 

  9 October, 2008 © 2008 K.R.Wade and Co Ltd prev page next page