6. Equity Investment

Wednesday, 6th June 2012 09:27 - by David Harbage

We are half way through our review of the prime types of asset that private individuals... as well as non-personal bodies (such as charities and clubs), will consider for their long term savings plans. This week we are looking at equity investment, which essentially is taking a stake in stock exchange listed businesses by owning company shares or stock. To own, however small, a part of the businesses whose products or services we use would intuitively seem to make sense: as investors, we can benefit from the corporate success we have contributed to create. Putting names to this, UK consumers could acquire a stake in their water provider (for example Severn Trent), electricity generator or provider (Scottish & Southern Energy), house & car insurer (Aviva), food or general retailer (Marks & Spencer), car or heating fuel (BP), landline telephone (BT), mobile phone (Vodafone), food manufacturer (Unilever), medicine offering (GlaxoSmithKline) and bank (Barclays). Beyond these essentials, investors may choose to take a stake in the companies that manufacture their home (Persimmon), cigarettes (Imperial Tobacco), beverages (Britvic or Diageo), cleaning products (Reckitt Benckiser), or provide their transport (First Group), holidays (TUI) and home entertainment (BskyB). Provided that these industry leaders remain successful, common sense suggests that some of the monies we pay for their services will eventually return, by taking a small stake in each company. Inflation seems to ensure that consumers pay ever higher bills; perhaps owning part of such businesses over the longer term (say a decade or more) can provide some degree of comfort and insulation. The historical evidence would seem to confirm the intuition: looking back to 1945 (or even further, as enabled by the annual Barclays Gilt Equity study publication amongst other studies), London stock exchange listed company shares have indeed clearly outperformed domestic inflation. (In a later article in this series, the writer intends to provide comparison data surrounding various asset classes, alongside meaningful benchmarks or comparators.) Closer inspection reveals that a collection or index of individual company shares - such as the FTSE All Share - will inevitably feature survivorship bias, with failing or acquired companies dropping out of the index. Similarly measures of inflation - such as the domestic longstanding Retail Price Index - typically incorporate and price a select group of products & services, which may not be relevant to all consumers. Before turning to look more closely at what an investment in individual company shares (or stock, as they are also known) entails, it is worth highlighting the term: Enterprise Value (EV). Put simply, the total worth of a business can be calculated by reference to its two prime sources of capital or ownership: simply adding the value of its ordinary shares to its debt. The latter is likely to comprise bank borrowings (overdraft and, typically, shorter term loans) and bonds (which were covered in earlier blogs). A predator wishing to acquire a business would have to buy all the ordinary shares (probably having to pay a premium in excess of the current share price), and assume or takeover all of the debt. It may, of course, be that the company has no outstanding bonds or bank debt; but rather possesses net cash. In such an instance, the Enterprise Value - think in terms of the cost of acquiring the whole business - would be the worth of its shares less the cash balance. For the purpose of calculating the value of a stock exchange listed company's equity, market capitalisation (the number of shares in issue multiplied by the current share price) is used. Beyond an assessment of what a predator would truly be paying for a business, Enterprise Value is also useful from the perspective of determining the returns attributable to the ordinary shares (equity portion of the capital) - after stripping out the cost of servicing the debt, or considering the income received on a cash balance. For example, a quoted company (which we shall call ABC) might have an EV of £100m, made up of equity £50m and debt £50m, while another firm (XYZ) also has an EV of £100m via equity £120m and cash £20m. Both ABC & XYZ generate annual gross profits of £5m, but if ABC's debt is a 10% fixed long term (say 10 year bond) and XYZ receives 1% interest on its cash pile, the reader can recognise that the earnings on ABC's equity will differ dramatically to that attributable to XYC's ordinary shares. It naturally follows that if this pattern of earnings were to continue in future years, shareholders in XYZ would expect to receive a useful dividend whereas the owners of ABC could not expect any payout. From the perspective of the investor in ABC's bonds, concerns might be raised about the ability of the company to pay the coupons (cost of this debt being only just met by profits), and the ratings agencies may take a dim view of the bond issue. The London stock exchange began life within the city's coffee houses as a means of raising monies to fund projects and, while probably best known for trading bonds, stocks and other various form of securities, it primarily exists to enable companies to have access to new long term capital - as opposed to going to banks or other financial institutions for shorter term borrowing needs. To obtain a full (normal) listing on the exchange, companies have to meet quite demanding standards of disclosure - which means providing the public with detailed information on a wide range of issues, from accounts of its financial health (notably balance sheet, profit & loss statements) to the immediate reporting of all events which could have a meaningful impact on the worth of the business. The latter would include advice of an acquisition or disposal of an asset of meaningful worth or significance, notification of large holdings on the company's share register, main board directors' dealings and any suggestion of a takeover approach. Bottom line, being a publically quoted company means furnishing all parties with equity or debt interests with new pertinent information at the same time - typically delivered via the stock exchange's regulatory news service (RNS). Besides these formal reporting obligations, listed companies endeavour to keep their shareholders informed of progress via the company's investor relations personnel. They, along with board level management will liaise with relevant industry analysts of the investment banks (termed the 'Sell side', they will also advise corporate clients). They broke their best ideas and recommendations to the larger investing institutions (the 'Buy side', featuring asset managers of life & pension funds), who in turn will separately meet and quiz senior management of the companies they own. Such informal meetings may also extend to private client gatherings, but logistical hurdles limit their practice. In the absence of any major controversy, the prime topics for discussion at such meetings surround current trading, balance sheet efficiency, immediate trading prospects, medium term strategy and the extent to which this might involve corporate activity and shareholder acquiesce. As a consequence, major investors in larger companies, with a meaningful analytical following, should not be surprised too often; theoretically, the market is said to be reasonably efficient in fairly pricing-in current opinions and news. However, while this assumption may hold true for the constituents of the FTSE100 index, experience suggests something rather different - exceptions occur on a perennial basis. The writer is referring to unanticipated disappointing trading, for example in January at Tesco, rather than unpredictable events which impact a share price such as the explosion and oil spill at BP's Macondo well in 2010 or, more positively, the Canadian bid last week for Logica. Clearly, less well-researched smaller businesses are more likely to surprise more often and companies listed on the Alternative Investment Market are not obliged to provide the same depth of disclosure as the LSE's fully listed firms. 'Caveat emptor' is a well used stock market saying, which translates from the Latin as 'Let the buyer beware'. Owning individual company shares or the wider equity market as part of a plan for long term savings may have a logical base, but it is undoubtedly a higher risk-reward asset with very significant potential to be volatile in the short term. History shows this, and intuitively an intelligent person would expect it - something illustrated by the very apparent difficulty in making predictions (even shorter term ones) surrounding the prime factors that will influence corporate success. For example, dear reader, try making accurate predictions on how the economic and political future of each of the countries within the Euro zone will progress over the next 12 months. In our next blog we will look at some of the factors that impact individual company shares, before going on to consider how the private investor can make a robust attempt at valuing stock exchange listed businesses. Our focus will unashamedly be on domestic stocks, which certainly does not mean that they are parochial or UK-centric. In addition we will endeavour to use examples of well known companies to illustrate our efforts to analyse risks and potential rewards. Although this series aims to make longer term judgements on the fundamental attractions and shortcomings of various individual kinds of investment, we will be adding a tactical (less strategic, shorter term) layer for equity - as befits its more volatile trading patterns which can offer obvious valuation anomalies or opportunities, according to the investor's viewpoint.