Investing in Equities
There are plenty of synonyms for equities - stocks and shares being the most common. They are simply an entitlement to share in the profits and dividends of a company. Normally we recommend investment in equities that are quoted on an official stock exchange or a recognised market. This means that equities can usually be bought or sold quickly and on a narrow "spread" (the difference between the buying and selling price). Smaller companies, however, may be more difficult to deal in.
Individual equity prices can be quite volatile and may be risky. This is why it is wise to invest in a basket of equities with a spread between the major economic sectors. By investing in a basket of equities it is possible to spread stock risk and to reduce the impact of volatility. Where it would be uneconomic to invest in a diversified basket of individual equities it may be appropriate to invest in a collective investment, which, itself, holds a basket of equities in order to achieve appropriate diversification and risk reduction.
There is no shortage of equities to choose from - there are around 2,000 listed in the UK alone although many of these are quite small. We tend to recommend picking individual holdings mainly from amongst the 350 largest companies. More modest portfolios should seek to emphasise collective investment.
Although equity investing can be risky it can also be very rewarding. The authoritative Barclays Equity Gilt Study 2010 shows that over the 110 years to 2009, UK equities produced an annualised real return (i.e. after allowing for the effects of inflation) of 5.0%. This compares to annualised returns for Gilts (UK Government bonds) and cash of 1.2% and 1.0% respectively over the same period. This is despite a fall in the equity index of 30.5% in 2008 alone. Taking discrete ten-year periods between 1906 and 2009 the Barclays Study shows that Equities provided superior returns to both Gilts and Cash over eight of the ten periods. It is important to understand that these numbers are based on holding a large basket of equities over these periods (the All Share Index in recent years) and that individual equities would have had vastly differing returns. So, although equity investing is generally rewarding, individual portfolio returns may diverge significantly from the average in the short term.
Over shorter periods equity volatility can be pronounced and this is why we urge investors to regard equity investment as a long term strategy. Where saving is being undertaken to achieve a specific goal at a known date (retirement for example) it may be appropriate to switch into lower volatility instruments such as Bonds as the date approaches. This reduces the damage from the possibility that the date on which investments must be realised coincides with a period of falling equity prices.
When discussing equity investment there are two widely-used valuation measures. The first is dividend yield. This is simply the latest annual dividend expressed as a percentage of the share price. So if one invested £1,000 into an equity with a dividend yield of 4% one would expect dividends over the next year of £40. In fact the situation is slightly more complicated than this because the annual dividend on equity is not fixed but is determined each year based on the profits of the company. So a company in trouble might be forced to cut its dividend or omit it altogether. But most companies, over time, tend to increase dividends at or above the rate of inflation. This is an important and valuable characteristic of equity investing.
The other widely-used valuation measure applied to equities is the price/earnings ratio (P/E). This is simply the equity price divided by its earnings (profits after tax) per share. The P/E Ratio can be thought of as the number of years of earnings that it would take to recoup the current share price. In general, equities with low growth prospects tend to be valued on relatively low P/Es and those perceived to have strong growth prospects tend to be valued on higher P/Es.
As noted above, there is a relationship between earnings and dividends. Companies (as a general rule) cannot pay out dividends for a sustained period that are not covered by earnings. In practice most companies tend to retain a proportion of their earnings in the business each year in order to increase investment and nurture future growth. Companies with good growth prospects tend to retain a higher proportion of their earnings than lower growth companies.
As a general rule we aim for a balance between growth and income from an equity portfolio. This balance can, however, be adjusted so that a client requiring relatively high income would have a different selection of equities from one with a focus on growth. There would, however, be a degree of overlap between the portfolios.
Investors tend to monitor the performance of their equity portfolios by comparison with an appropriate Index. In the UK the most commonly quoted Index is the FTSE 100 which tracks the performance of the 100 largest equities. We also use the FTSE Actuaries All Share Index which is based on the performance of a larger sample of UK equities. We do not seek to replicate or compare directly to this as all indices (this included) have their own particular weaknesses and idiosyncrasies.
Apart from providing a convenient comparison for performance purposes indices also offer valuation comparisons since it is possible to compare the P/E and dividend yield of the Index with those of the portfolio or of individual stocks. While it is possible to construct an equity portfolio offering, say, a dividend yield of double the dividend yield on the index we strongly advise against such an extreme position because such a portfolio would be very dependent on stocks with poor growth prospects and possible dividend cuts in store.
To summarise; equities offer good returns if held for the long term. These returns come both from capital appreciation and from initially modest but growing income. The risks of holding individual equities can be mitigated but not eliminated by holding a well-diversified portfolio.