8. Equity diversification

Tuesday, 19th June 2012 11:14 - by David Harbage

In the previous blog we looked at how the worth of profits can be assessed, as a means of placing a value on listed company shares.

This week, we will take a broader view of the universe of equity investment available to the personal investor – but occasionally referring back to the often controversial subject of determining a reasonable or fair price. 

The prime means of assessing fully listed company shares on the London Stock Exchange is to view the FTSE All Share index. Currently comprising 621 stocks, the index recently ‘celebrated’ the 50th anniversary of its inception on 10 April 1962. The All Share’s constituents can be broken down into the largest 100 companies (FTSE100 index, which began life in 1984, and currently accounts for 81% of total market capitalisation of UK equity), the next 250 stocks (FTSE250 index, constructed 1992, represents 15% of total worth), and the balance of 271 companies (FTSE Small Cap 2%). Beyond these, there is a further circa 130 stocks within the FTSE Fledgling index: they possess a full listing on the London stock exchange, but limited market capitalisation and liquidity (pricing & dealing) makes them ineligible for the All Share index. Another 1,100 companies have a listing on the London stock exchange’s Alternative Investment Market (AIM), and make up the remaining 2% of total listed equity worth.

Considerable corporate value, of course, also resides in non-listed businesses whose well-known names feature the pharmaceutical retailer Alliance Boots, retailer John Lewis (which is fully owned by employees, and includes Waitrose) and the airline & tour operator Virgin Atlantic. While not typically available for public investment, a stake in private equity can be achieved via stock exchange listed vehicles - companies like 3i and Electra - or the use of collective investment schemes. But our focus in this article will be on opportunities provided by larger listed businesses in the FTSE All Share index which, besides size, can also be broken down by reference to their industry sector, economic sensitivity and geographical base.

Based on the FTSE All Share index as at 31 March 2012, the largest business segments of the domestic equity market are: natural resources 28.8% (notably oil & gas 17.7% mining 11.1%) financials (banks & insurance) 20.8%, consumer goods 13.5%, consumer services 9.4%, industrials 8.6%, healthcare 7.2%, telecommunications 6.2%, utilities 3.9% and technology 1.5%. The ten largest companies on that date were: Royal Dutch Shell 7.8% of the FTSE All Share index, HSBC 5.6%, BP 4.9%, Vodafone 4.9%, GlaxoSmithKline 4.0%, British American Tobacco 3.5%, Rio Tinto 2.7%, BG 2.7% and BHP Billiton 2.3%. In total these blue chip stocks account for 38.4% of the FTSE All Share index, but 45.6% of the total worth of the more concentrated FTSE100 index. Each of these are multinational companies, with only a very small proportion of sales and profits arising in, or being truly attributable to, the UK. Accordingly, their asset worth and earnings typically reflect the global economy – rather than the domestic one – as is reflected in the fact that often companies disclose their revenue, profits, dividends and accounts in the US dollar.

However, the businesses can be differentiated by reference to the economic sensitivity, or otherwise, of their underlying industries. Mining is, as we have discussed in other blogs, a prime cyclical business sector as are banks (in their core role of lending) and general retailers; whereas examples of non-cyclical segments would feature healthcare, utilities, food retail and telecommunications. Investors can debate how resilient a range of other sectors might be to a downturn in economic activity – with an eye on the global outlook (not necessarily the domestic perspective), in terms of how essential the product or service proves to be. For instance, the writer would argue that tobacco was non-cyclical, but recognises that many other perceived defensive industries such as manufacturers of food, drink and cleaning products may be less resilient than intuitive expectations. Other sectors will feature both cyclical and less economically sensitive businesses.

The bottom line is that diversification in equity investment makes eminent sense, even if the investor possesses a strong opinion on the health of the global economy – or the direction in which it is heading – and particular stocks, as markets are reasonably efficient in pricing-in anticipated outcomes, be they ‘top down’ macro-economic or ‘bottom up’ company specific. If consensual opinion anticipates a marked slowdown in the pace of economic activity, this will already be reflected in the valuation of individual sectors and company shares (evidenced, for example, by price/earnings multiples). This forward-looking ability to discount anticipated outcomes is also visible when considering the business cycle from a structural, rather than cyclical, perspective.

When a company introduces a new product or service, its stock price will reflect its ‘first mover’ advantage and anticipate strong earnings via supernormal profit margins – but soon, other entrants (attracted by those profits) will compete for the available revenue, which will depress margins, perhaps to the point of some of the competing firms producing losses and going out of business, before a more stable level of profit is earned by those remaining. This illustration might help to explain why some younger companies are on exceptionally high PE multiples, while mature ones will be on low ratings –per last week’s examples of ASOS and United Utilities respectively. In the early years, pioneer companies will be reinvesting most of any earnings back into the business – Vodafone would represent a classic instance - before only paying a dividend once it was well established.

To only invest in high growth, non dividend paying, individual company shares would represent a higher risk-reward strategy. Certainly those who remember the technology-media-telecom boom at the turn of the new millennium would testify to that suggestion. Historically, more assured returns have arisen from owning equities which combine a low PE rating but also offer a reasonable dividend yield. Industry analysts seek to assess the PE ratio (with a lower number representing an apparently cheaply priced stock), with their forecasts of earnings growth – as a means of assessing if the current valuation (as represented by the PE) fairly reflects the prognosis for profits. The resultant ratio is termed the PEG (PE divided by growth in earnings); for example the FTSE All Share index is currently priced on a historic PE ratio of 9.5x and, if consensus expectations for profit growth was 9.5% per annum in 2012, then the PEG ratio on the overall UK equity market would be 1.0 for the immediate calendar year. Based on that, a company share featuring a lower PEG than 1.0 would imply that the stock was cheap, and a PEG of higher than 1.0 would indicate the opposite.

The writer would recommend that prospective investors should employ several different means of assessing the worth of equity, rather than rely on any one system. For example the PEG methodology is less than rigorous, as analysts typically only publish – and have confidence in – earnings forecasts for the next two years. Allied to that, investors will want to reassure themselves concerning the quality of the E (reported earnings) number and, as we have seen above from the business cycle, the progression of earnings over five or ten years could vary dramatically from the next two years (used by the calculators of PEG). Last week we touched on methods of assessing the current worth of a company which is expected to feature strong future, rather than current, earnings. Investors might also wish to be wary of low PEG stocks which could imply a lack of faith in the current stated level of earnings or belie the possibility that, after two reasonable years’ growth in earnings, profits may be set to decline.

Although growth in earnings offers clear rationale for owning company shares, something borne out by historic evidence of a strong co-relationship between the worth of profits and the capital asset that produces them, there are other means of making an assessment of individual stocks. According to an equity investor’s perspective or particular objective, the focus may be upon the net asset value of the business (that is attributable to shareholders) or to dividend income. Many private individuals who invest in company shares have done so because they warm to the prospect of owning real assets such as ‘bricks & mortar’ property - via stock exchange listed equity, which is priced at a discount to the underlying net asset value, and can readily be traded - and sharing in the resultant, reasonably reliable, rental income. Taking a stake in companies which own a large portfolio of properties (which may feature one or more of offices, shops, business parks and industrial units – both at home or overseas) such as FTSE100 constituents British Land and Land Securities, represents such a strategy - a sector we will feature in one of the UK Equity Market commentaries blogs in due course.

Dividend income is clearly another aspect of equity investment which attracts long term personal savers, especially when it exceeds that available on most cash-based investments. While some individuals who require income will seek to own the highest yielding stocks, the results may not deliver the most reliable income producers or those likely to distribute higher payouts in future. For example, MAN Group shares currently offer the highest apparent dividend income amongst the FTSE100’s constituents - an income yield of 20%, based on dividend payments of the last year, but in the current year the prospect of lower earnings may lead to a cut in the dividend. If maintained, and based on the management’s belief that profits will recover to previous year levels, it would mean an uncovered (by profits) dividend. Investors should investigate the extent of a company’s ability to pay (compare how well earnings cover dividends, on a per share basis), both for the current year, on brokers’ forecasts and for the longer term prospects. In addition, it is important to distinguish between normal – hopefully a progressive payout policy – and special, exceptional dividend payments, which may not continue in future. The quality of the earnings, and in particular threats to cash flows (planned acquisition, major capital expenditure or regulatory constraint), should also be examined to gain comfort on the sustainability of future earnings, and therefore dividend payouts.

In looking at equity investment, we have unashamedly focused on the UK stock market – rather than commented on individual company stocks overseas – in recognition that the constituents of the FTSE All Share index already reflects the global economy and opportunity, rather than the domestic one. Although valuation is typically a little more expensive (based on earnings multiples, published by the likes of MSCI and FTSE) than UK equities, taking a direct stake in other stock markets can undoubtedly add another layer of potential reward (via particular global leaders in industries barely represented in the UK, such as technology), notwithstanding the risk of moving further from a £-based currency position. Unless the prospective investor has local knowledge of, and confidence in, particular overseas companies, an investment into a collective investment vehicle – featuring diversification, via professional portfolio management or index tracking – is probably likely to offer a more satisfactory, reliable experience.

Next week we will be taking a look at some of the other means of owning equity, beyond individual company shares, including exchange traded funds and structured products – which extend across other types of asset too.

The Writer's views are their own, not a representation of London South East's. No advice is inferred or given. If you require financial advice, please seek an Independent Financial Adviser.