Understanding Equities

Transcription

1 Understanding Equities Contact us If you would like to know more about how AMP Capital can help you, please visit ampcapital.com For your local contact, please visit ampcapital.com/contact or Important notice to all investors: While every care has been taken in the preparation of this document, AMP Capital Investors Limited (ABN , AFSL ) makes no representation or warranty 2014 as to the accuracy or completeness of any statement in it including, without AMP Capital limitation, Investors any forecasts. Limited Past performance is not a reliable indicator of future ABN performance This document has been prepared for the purpose of providing AFSL general information, without taking account of any particular investor s objectives, financial situation or needs. An investor should, before making any investment decisions, consider the appropriateness of the information in this document, and seek professional advice, having regard to the investor s objectives, financial situation and needs. This document is solely for the use of the party to whom it is provided. AMPC_UnderstandingEquities_0114_Retail

2 Understanding Equities About equities at AMP Capital Delivering outstanding investment outcomes At AMP Capital, we are committed to delivering outstanding investment outcomes for clients. By drawing on information across investment styles and asset classes, we believe this can help us reduce risk and make better investment decisions for our clients. Clients benefit from our information advantage Our equities team has been investing on behalf of clients for more than 40 years. With expertise across quantitative and fundamental equity approaches, we are able to draw on information across a number of investment styles and asset classes. We are also one of the largest and most experienced investors in Australian equities, and our global equities capability includes teams spanning Asian equities, global listed infrastructure, global listed real estate and China A-Shares. Information sharing leads to better results for our clients For us, success is expert investment teams coming together to discover the best possible insights and investment opportunities for our clients. We offer clients the benefit of shared insights across our investment business, including macro markets, environmental social and governance, fixed income, real estate and infrastructure. Our on-the-ground specialists across the globe also provide local and global insights, offering clients access to some of the world s most attractive investment opportunities. For further information Please visit ampcapital.com/contact or inquiry@ampcapital.com Table of contents What are equities? 3 Why invest in equities? 3-4 Ordinary or preference shares? 4 Risk and return characteristics 5 Investing in equities > > Ways to invest 5 > > How do equities fit into my portfolio 5 > > Equity strategies 5-6 > > Market indices 7 > > The performance of equities and the psychology of investing 7-8 > > Measuring performance 9 > > Risks of investing in equities 10 The importance of active management 10 2

3 What are equities? Equities, or shares as they are commonly called, are units of ownership in a company. When you buy a share, you become a part owner or shareholder of the company. This means you often have the right to vote on members of the board of directors and other important matters facing the company. If the company distributes profits to its shareholders called dividends you will likely receive a proportionate share. Companies issue equities to the public for a number of reasons, one of the main ones being to raise money to fund business growth. The table below provides an overview of the different types of equities available to investors. Type of equity Description Cyclical > > Issued by companies affected by ups and downs in the overall economy > > These equities typically relate to companies that sell discretionary items that consumers can afford to buy more of in a booming economy and will cut back on during a recession > > The share prices tend to fall during periods of economic recession and rise during economic booms > > Equities in mining, heavy machinery, communications, financial, health care, technology, transportation and home building companies are often regarded as cyclical Defensive > > Utilities and consumer staples tend to be stable and not affected by cyclical market movements, since demand for their products and services continues regardless of the economy > > Companies producing staples such as food, beverages, pharmaceuticals and insurance are often regarded as defensive shares > > For investors, defensive sectors provide a balance to portfolios and offer protection in a falling market Blue chip > > Issued by companies with long histories of growth and stability > > Blue chip shares usually pay regular dividends and generally maintain a fairly steady price trend Income > > Have historically paid larger dividends, compared to other types of shares > > This type of share can be used to generate income without selling the shares, but you need to take into account the cost of the share relative to its typical dividend Growth > > Issued by entrepreneurial companies experiencing a faster rate of growth than their general industries > > These shares may pay little or no dividends if the company needs most or all of its earnings to finance expansion Why invest in equities? Equities are classed as a growth asset as they are essentially linked to the revenues of the company s business. They appeal to a range of both retail and institutional investors because they offer attractive income opportunities and exposure to a broad range of industries and sectors that provide growth and diversity within an investment portfolio. Australia continues to have one of the highest levels of share ownership in the world. Research by the Australian Securities Exchange shows that share ownership is increasing across the board, among all age groups, incomes and education levels. These days, 38% of adult Australians 6.68 million people own shares 1, either directly or through managed funds. 1. Australian Share Exchange, Australian Share Ownership Study, November

4 The key benefits of investing in equities include: Capital gains over the long-term Historically, equities have provided some of the strongest after-tax investment returns over the long-term. By owning equity in companies with growth potential, investors have the opportunity to benefit from capital gains as the asset grows in value over time. Investors enjoy unlimited participation in the earnings of the firm. Of course, investors cannot expect the company to pay out all its profits in a form of a dividend as this may come at the risk of future profitability and a lower share price. A good source of income The dividend yield on equities is another important source of return. Unlike term deposits, dividends from equities can have inflation built into earnings where companies are able to pass cost increases onto customers. Highly liquid Equities are traded on major stock markets around the world. They are highly liquid which means that they can be converted into cash quickly and with minimal impact to the price received. Unlike direct investments, there is relative ease in the transfer of ownership and the movement of equities. Tax advantages The after-tax performance of equities is lifted by dividend imputation, a tax benefit not shared by other asset classes. The dividend imputation system allows investors who have been paid a dividend to take a personal tax credit (franking credit) since the company has already paid tax on the dividend. Limited liability One of the unique features of owning equities is the notion of limited liability. This means that when you own equity in a company and in the event that company loses a lawsuit and must pay a large settlement, creditors can t come after your personal assets. Your liability is limited to the amount invested in the company. Corporate control Equities come with certain rights including the voting rights to which the investors are entitled. The level of corporate control depends on whether the equity is common or preferred and on the size of your shareholding. This is explained further in the next section. Ordinary or preference shares? Equities fall into two different categories ordinary or preference: Ordinary Ordinary shares represent the majority of shares held by investors. When you own an ordinary share of a company, you usually have one vote per share that entitles you to participate in the election of the board of directors. Preference Despite their name, preference shares have fewer rights than ordinary shares, except in one important area dividends. Companies that issue preference shares usually aim to pay consistent dividends and preference shareholders have first call on dividends. In the event that a company is liquidated, preference shareholders have prior claim to assets over ordinary shareholders. This feature allows the company to raise capital from venture capitalists before it goes public because most venture capital deals are structured as preference shares. Comparison of ordinary and preference shares Ordinary shares Have a right to vote Have the right to maintain a certain percentage in the company Do not know the dividend amount you will receive in advance Dividends can increase as the company grows Preference shares Do not have any voting rights No rights over the stake in the company Dividends are fixed (although in some periods there may be reduced or no dividends) Fixed dividend amount is usually higher than the dividends on common equities In summary, both ordinary and preference shares allow you to participate in the equity stake of companies; however, ordinary shares are more popular because they allow more potential for future growth, while preference shares offer current income through fixed dividends but limited future growth potential. It should be noted that shareholders rank behind debtors in relation to their rights to returns from a company. There are also risks associated with investing in equities and these are outlined on page 10. 4

5 Risk and return characteristics The relationship between risk and return is often represented by a trade-off. Generally speaking with equities, the more risk you take on, the greater your possible return. Equities rank high on the risk-return scale Exchange traded funds Another way investors can obtain exposure to the market without directly buying shares in individual companies is to consider buying exchange traded funds (ETFs). These funds are also bought and sold on the share market just like shares. ETFs seek to track the underlying index by investing in a basket of securities reflecting that index. They will also provide distributions paid by securities included in the fund. ETFs are considered to have a number of advantages including low management fees compared to other funds. Return Bonds Equities Private equity and hedge funds How do equities fit into my portfolio? Equities offer a broad range of investment opportunities for investors seeking growth and diversity in their investment portfolios. They would most likely be included in the growth part of a portfolio. Due to the focus on growth, it is recommended that investment is for a minimum of five years. Cash Risk Source: AMP Capital. For illustrative purposes only. Investing in equities Ways to invest Investing directly Direct investing is when you invest in equities in your own name. Direct investing gives you greater choice and control over what to invest in as you are making the choices about what to invest in. When considering investing in shares, ask yourself: > > What is my time frame for investment? > > What sort of return do I want to achieve? > > What level of risk am I prepared to take? > > Will I actively trade shares or take a long-term buy-andhold approach? > > Do I want income from dividends or capital growth in the value of my shares? Equity strategies Value and growth The two most common styles of investing are value and growth strategies. Both approaches aim to outperform the market and generate capital growth over the long-term, however the way in which they do this is quite different: Investing indirectly Indirect investment commonly takes the form of cash management trusts, property trusts, and managed share investment funds. Managed funds hold and manage a portfolio of assets on behalf of their investors, with buy and sell decisions being made by investment professionals. In the case of an actively managed share fund, a fund manager follows the market, buying and selling shares in an effort to outperform the market. Passively managed funds on the other hand do not try to pick particular stocks or time the market, but rather track an investment index in an effort to provide returns consistent with the overall market. Managed funds are offered to investors through a product disclosure statement and with an unlisted managed fund, the manager sets the price of the units available based on the fund s net asset value. The popularity of managed equity funds can be attributed to their simplicity one investment can provide access to a professionally managed portfolio of assets. Listed managed funds are purchased through share markets in the same manner as ordinary shares and are an increasingly popular tool for investors seeking to accumulate or preserve wealth. They can also be effective income producing investments. Value strategies Aim to buy cheap, looking for equities believed to be priced below the company s intrinsic value; look to sell when the share price reaches or exceeds fair value Greater focus on the value of the share than the growth potential of the company Manager tends not to follow the crowd or chase after popular shares that may be overpriced Growth strategies Focus on companies that show potential of above-average growth, even if the share price appears expensive Aim to maximise their capital gains, even if this comes at the expense of receiving less income in the form of dividends 5

6 Long-short Long-short equity strategies provide investors with the opportunity to benefit from rising and falling markets by sourcing profits from both positive and negative share price movements. They seek to do this by capitalising on companies which are seen likely to either outperform or underperform relative to others, and by minimising potential loss in falling markets. The overall aim of a long-short strategy is to deliver stronger returns than a long only strategy by offering more market exposure. Long investing involves buying a share with the expectation that its price will rise or outperform an underlying benchmark. Short investing aims to profit from a fall in a stock s share price. It involves selling a borrowed share with the expectation that the share will fall in value, and agreeing to purchase the share back at a later date. This concept is best illustrated in the example shown below. Sector rotation Since not all sectors of the economy perform well at the same time, managers aim to gain exposure to multiple sectors through sector rotation. Additionally a portfolio manager may attempt to profit through timing a particular economic cycle and exiting a sector as it begins to struggle while entering another on the rise. These strategies are popular because they can improve risk-adjusted returns and automate the investing process. However, investors should recognise that sector rotation is a general theory based on past performance and that there is no guarantee that any particular share will follow these patterns in the future. An example of a short trade An investment manager has been tracking company XYZ, and believes its share price is overvalued. The manager s research team has identified the company as having a negative growth outlook based on eroding margins and lower cost competitors entering the market. To act on this belief, the investment manager decides to short sell shares in company XYZ. As the manager does not own any shares in the company, it borrows one million shares from a broker who lends them for a fee. The manager then sells the shares in the market at a price of $2 per share, receiving $2 million from the trade. After some time, the share price of company XYZ falls, as the manager predicted. When the shares are trading at $1.50, the manager purchases one million of the shares at a total cost of $1.5 million. The manager then returns the shares to the broker. From this trade, the investment manager has made a profit of $500,000. This excludes interest earned, dividends (which are owed to the lender) and borrowing fees. $3,000,000 $3,000,000 Borrows 1 million XYZ shares from broker XYZ Stock Returns 1 million XYZ shares to broker $2,500,000 $2,000,000 $1,500,000 $1,000,000 $500,000 SELLS XYZ per share $2m $1.5m BUYS XYZ per share PROFIT $500,000 $0 Day 1 Day 2 Day 10 Day 20 Day 30 For illustrative purposes only 6

7 Market indices Equities are grouped in indices on share markets, by size and by sector. The S&P/ASX 200 index, for example, groups the 200 largest equities by market capitalisation. This is calculated by multiplying the number of shares in circulation by the prevailing share price. In Australia, fund managers generally consider the S&P/ASX 200 index to be the market benchmark. The table below shows some popular indices and the markets they reflect: Index S&P / ASX 200 S&P 500 The Dow Jones Industrial Average The Nasdaq composite Description The investable benchmark for the Australian equity market. The S&P/ASX 200 is comprised of the largest 200 companies listed on the Australian Securities Exchange by market capitalisation. Includes 500 of the most widely traded shares in the US. It covers about 70% of the market s total value. Price weight average of 30 of the most influential companies in the US which represent about one quarter of the value of the total market. It does not represent small or mid-size companies. Broad based market capitalisation weight index of stocks in all three NASDAQ tiers: Global Select, Global Market and Capital Market. The performance of equities and the psychology of investing Investors have developed mixed feelings about investing in shares in recent years, given the degree of market volatility. When markets are volatile, emotional instincts begin to play a role in investment decisions. This is precisely where the rational investor stands to benefit by persisting with a long-term investment strategy to yield long-term results. The chart below illustrates how investing in equities over longer periods improves the probability of a positive return. Share markets do have their ups and downs, but over time the market has always recovered and moved on to new highs. This highlights the importance of maintaining a long term discipline when investing in growth assets like equities. While equities experience occasional sharp setbacks, the long-term trend is up Actual index level 8000 Subprime concerns 7000 Lehman collapse 6000 US Fed questions sustainability of growth 5000 Sharemarket crash Asian crisis 4000 Gulf War I Oil hits $ Global bond markets collapse Russian crisis 9/11 terrorist attacks Gulf War II Global financial crisis European debt concerns Source: History and the Australian share market, Global Financial Data, AMP Capital, January 1900 July Past performance is not a reliable indicator of future performance. 7

8 As humans, the herd mentality is very strong in everything we do. Emotions, not logic, can rule the average investor s decision making as they are heavily reliant on social norms and trends. It can be the case that the investors who go against the sentiment early make the most money. The chart below is a visual representation that explains the relationship between investor feelings and judgments. It is important for investors to learn and understand the mental cues that are present in the market and how to prevent them from clouding investment decision making. The cycle of market emotions Euphoria Anxiety Thrill Denial Excitement Optimism Maximum Financial Risk Fear Desperation Maximum Financial Opportunity Optimism Panic Relief Capitulation Hope Despondency Depression For illustrative purposes only > > Optimism: A positive outlook leads us to buy a share. > > Excitement: As things start moving our way, we anticipate and hope that a possible success story is in the making. > > Thrill: The market continues to be favourable and at this point we have complete confidence in our trading strategy. > > Euphoria: This marks the point of maximum financial risk but also maximum financial gain. With high returns flowing, we begin to take on more risk. > > Anxiety: The markets start to show their first signs of depreciation but we believe the long-term trend is higher. > > Denial: The markets don t turn but we maintain mediumterm hope of an improvement. > > Fear: Reality sets in and we lose confidence in our investment strategy. > > Desperation: At this point, all gains are lost and we are anxious to do anything that will bring our positions back into the black. > > Panic: We feel like we are at the mercy of the market and have absolutely no control. > > Capitulation: Having reached our breaking point, we are keen to get out of the market to avoid bigger losses. We sell our positions at any price and are content with this decision. > > Despondency: After exiting the markets, we do not want to buy stocks ever again. However, this rare point marks the point of maximum financial opportunity. > > Depression: At markets picks up, we regretfully look back and analyse what went wrong. > > Hope: Eventually we come to the realisation the market has cycles and we begin to start analysing new opportunities. > > Relief: The markets are turning positive again and we see our prior investment come back around. We regain faith in our investment abilities and the cycle starts over again. 8

9 Measuring performance Below are some of the key metrics that investment managers commonly use to evaluate whether a particular share appears to be a good investment opportunity. Metric Formula Description Earnings Per Share (EPS) Net earnings divided by outstanding shares The higher the earning per share, the better. This measure is helpful in comparing one company to another, assuming they are in the same industry, but it doesn t tell you whether it s a good share to buy or what the market thinks of it. Price-to-earnings (P/E) ratio Share price divided by EPS The P/E ratio tells you whether a share s price is high or low relative to its earnings. The higher the P/E the more the market is willing to pay for the company s earnings. Some investors read a high P/E as an overpriced share and that may be the case, however it can also indicate the market has high hopes for this share s future and has bid up the price. Conversely, a low P/E may indicate a vote of no confidence by the market or it could mean this is an opportunity the market has overlooked. Price to Book ( P/B) ratio Dividend yield Return on equity (ROE) Share price divided by book value per share Book value per share is calculated by subtracting liabilities from assets then dividing the amount by the number of shares in circulation Annual dividend per share divided by the price of the share Net income divided by the book value This measurement looks at the value the market places on the book value of the company. The book value represents how much would be left once the company settled its debts and sold off its assets. A company that is a viable growing business will always be worth more than its book value for its ability to generate earnings and growth. Like the P/E, the lower the P/B, the better the value. This measurement tells you what percentage return a company pays out to shareholders in the form of dividends. Older, well-established companies tend to pay out a higher, more consistent percentage than newly established companies. Measures how efficiently a company uses its assets to produce earnings. While ROE is a useful measure, it can give a false picture, so never rely on it alone. For example, if a company carries a large debt and raises funds through borrowing rather than issuing share it will reduce its book value. A lower book value means you re dividing by a smaller number so the ROE is artificially higher. There are other situations such as taking write-downs, share buy backs, or any other creative accounting methods that reduce book value, which will produce a higher ROE without improving profits. Real rate of return ROE less inflation Adjusting the nominal return to compensate for factors such as inflation allows investors to determine how much of their nominal return is actually real return. 9

10 Risks of investing in equities Whilst share markets have historically produced higher returns than cash or fixed income over the longer term, the risk of capital loss exists especially over the shorter term. You should also be aware that past share market investment performance is not an indicator of future performance. Specific risks relating to the shares of individual companies include industry risk factors as well as disappointing profits and dividends, management changes or reassessment of the outlook for the company or industry. Where a company is geared there is a risk that the value of the company and/or its returns may be affected by factors such as increased borrowing costs or a change in interest rates. Share markets are also subject to volatility, which is the result of large fluctuations in the value of shares based on a range of factors. International equities are also influenced by global economic trends and individual country risk (e.g. political environment and laws). These investments also carry currency risk for Australian investors. Capital gains may occur when the Australian dollar depreciates relative to other currencies and capital losses may occur when the Australian dollar appreciates. However, this may be offset by hedging against movements in the value of the Australian dollar. Equity funds invest in companies that are listed on the share exchange. This means that they will be affected by any risks associated with these companies, such as how they perform, their strategy, management, how sustainable their earnings are, and other factors that affect the value and performance of a company. Being listed on a share market also means that the value of the equity prices for these companies can move up and down significantly because of market sentiment, world and economic events, and other types of information that can move markets. The importance of active management The basic premise of active management is that pricing anomalies exist in the market and these can be exploited by investors. As markets are not always efficient, with the right research and methodology, a good manager can identify undervalued securities to invest in, thereby adding excess return over the performance benchmark. They seek to do this by understanding whether a company s earnings are likely to rise or fall in the future. Rather than rely on broker forecasts, which have a poor track record in projecting earnings, a dedicated team of analysts will often carry out their own research on companies, including face-to-face meetings with management to determine the intrinsic value of a company s share price. Active managers can play a valuable role navigating portfolios through an environment of heightened market volatility, thereby reducing volatility in short to medium-term investment performance. In recent times, the tendency for all equities to move in lockstep with each other, regardless of company fundamentals, has diminished. Over shorter timeframes, investors stand to benefit from these mispricing opportunities in equities. Some active managers will be more successful than others, depending on their respective skill sets, so it s important that investors make the right choice when hiring a manager in the context of their needs and the prevailing environment. Contact us If you would like to know more about how AMP Capital can help you, please visit ampcapital.com Important notice to all investors: While every care has been taken in the preparation of this document, AMP Capital Investors Limited (ABN , AFSL ) makes no representation or warranty as to the accuracy or completeness of any statement in it including, without limitation, any forecasts. Past performance is not a reliable indicator of future performance. This document has been prepared for the purpose of providing general information, without taking account of any particular investor s objectives, financial situation or needs. An investor should, before making any investment decisions, consider the appropriateness of the information in this document, and seek professional advice, having regard to the investor s objectives, financial situation and needs. This document is solely for the use of the party to whom it is provided. AMPC_UnderstandingEquities_0114_Retail