Equity Investing

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There are two principal ways of investing in companies. At the lower end of the risk spectrum is making a loan (corporate debt), usually in return for a fixed rate of interest. Here we explore the higher risk alternative of investing in equities, more commonly referred to as buying shares in a company.

In the event a company fails, shareholders rank last, so there is a risk of losing the full value of the amount invested. However risks may be mitigated by diversifying across many companies, and in the event of success, the upside is unlimited, which is the obvious attraction.

Investing in shares is a means of participating in the profits generated by the individual companies whose shares are traded on the stock market. Companies raise money by issuing shares and, in return, investors who buy them expect companies to provide a return on their investment. The return on this investment comes from two sources; first is income, which is provided by dividends paid by the company; second by capital appreciation in the value of the shares.

To illustrate how and why the value of shares can rise or fall, we consider the entitlements that ownership of a share in a company gives. Because of the way in which company law and accounting conventions are drafted, individuals who provide equity capital (by buying shares in a company) rank last in a winding up of the company. When a company is wound up as insolvent, this is generally not good news, since all other creditors will be satisfied before the shareholders. However, under normal trading conditions, the equity shareholders are legally entitled to a claim on whatever is left over after other creditors, suppliers and providers of capital have been paid. This effectively means that a company has to, by law, pay its rent and interest to its bank, or bond holders, and tax, before being able to pay out a dividend to its shareholders.

Thus, returns to shareholders are more volatile than returns to property investors, or to bond holders in general, since there is no guarantee that any money will be returned if the company goes bankrupt. There is no contractual basis for the receipt of any income (unlike rent or interest). Indeed some companies routinely pay no dividends for extended periods of time preferring to reinvest more capital back into the company to accelerate its growth. This is particularly common in US Technology companies and although financial theory teaches that assets are only valuable if they produce income, Microsoft became the largest company in the world (by market value) before it ever paid a dividend. But, on the other side, there is the possibility of very long-term real gains in both capital and income if the company is successful.

The quality of the management in growing revenue and controlling costs has a direct impact on shareholders’ interests, and the ability to negotiate lower tax rates is also important in determining how much remains for distribution to shareholders. How much is distributed is entirely at the discretion of management. This explains why fundamental analysis of companies places such a high value on strong management teams, and why long serving successful CEOs get good book deals.

As financial assets are often valued in relation to the income they produce, most financial models focus (or should) on the growth in dividend per share as a key element in valuing investments. Over time, the second source of return is capital appreciation i.e. the company’s shares go up as its business grows. This adds a further element of volatility because of the varying multiple of earnings placed on a company: the earnings may vary and the multiple placed on those earnings by stock market investors may also vary. Earnings are usually more volatile than dividends, as directors tend to smooth dividend payments even if earnings are volatile.

Because, over the long term, economies and companies have grown, equities have tended to give a real return above and beyond inflation. This is not guaranteed, but is the primary reason to invest in equities. In times of economic growth they should generate strong real returns. In times of economic slowdown, however, they may cost you both income and capital. This is why equity investments tend to come with a good number of health warnings.

Further individual risks to investing in shares will depend on the nature of the company in which you are investing: it may be very small; it may have a high amount of debt; it may operate in an industry where regulatory change can be rapid and unpredictable; it may have extremely tough competition, or enjoy a protected monopoly.

In order to reduce risks attached to a particular share, the prudent investor will diversify a portfolio across a number of shares so that negative results from any one company can be offset with positive results from another. Ultimately, diversification across all the companies in a particular industry, or sector, or indeed index, produces the most diversification and reduces the risks associated with one share. Index investing, i.e. buying and passively holding a portfolio of all the shares in an index, is discussed in another ‘Optimus Explains’ note.
This paper is prepared by Optimus Capital LLP and is not intended to be relied upon as a forecast, research or investment advice, and is not a recommendation, offer or solicitation to buy or sell any securities or to adopt any investment strategy. This document contains general information only and is not intended to represent general or specific investment or professional advice. The information does not take into account any individual’s financial circumstances or goals. An assessment should be made as to whether the information is appropriate in individual circumstances and consideration should be given to talking to a financial or other professional adviser before making an investment decision. Investment involves risks to both capital values and to levels of income received. Past performance is no guide to future results, and you may not receive back all the money invested.