Investment managers talk much of asset classes and the importance of not having all one’s eggs in one basket. In the investment world, here we talk of equities (shares), bonds or fixed interest securities, cash or cash equivalents, property, commodities and perhaps hedge funds. By spreading one’s investment capital around, hopefully because not all of these assets are completely correlated (all move in the same direction at the same time), the investor achieves capital protection, reduced volatility and potential growth. Discretionary fund managers construct portfolios with asset allocation driving investment strategy; percentage allocations will vary over time depending on the investment manager’s assessment of the changing macroeconomic landscape.
Equities, whilst considered the riskiest asset class is the investment arena where I spend most of my time. Whilst considered to be the risk capital of a listed company, with this comes significant investment return potential. In simple terms, these returns can come by way of share price appreciation and / or dividend income in addition. Companies come in different sizes from FTSE 100 Blue Chips, household names such as BP, Marks & Spencer and Vodafone to mid caps such as Halfords and Stagecoach down to much smaller companies. While not always the case, the larger the company is, the lower the risk or volatility in the expected return. A company’s size (or market capitalisation) equates to its number of shares in issue multiplied by its share price at any one moment in time.
Investing into companies brings the potential to gain international exposure as most do business overseas, for example in faster growing markets such as China and South America. This brings the ability to benefit (or lose) as a result of foreign exchange movements. But the main reason is to benefit from a company’s ability to grow profits over time as the stockmarket will reprice its shares (higher) accordingly. Growing annual dividend payments also serve as a key draw to equities (dividends are paid out of profits) and certainly in a low interest rate environment as now, this has attracted many new investors to the market. Above 5% annual dividend returns are commonplace and achievable today.
Shares themselves can be classified in different ways with different shares appealing to different types of investor. A ‘yielder’ is a share (of a company) that pays a high level of dividend to its investors. Often popular with older investors looking to boost their annual income levels, these might include utility companies (such as gas, electric, water and telecoms). However economically defensive sectors like Pharmaceuticals and Tobacco also tend to pay generous dividends. While income is important here, there is clearly also the potential for the share prices to rise which would give “total returns” in excess of just the income payments over time. A cursory glance at the performance of Imperial Brands over the past 15 years shows a very handsome appreciation in share price value.
A capital growth share tends to pay little (if any) of its profits out as dividends, deliberately by the way, as certain companies prefer to re-invest all or a high proportion of their profits into the business for ultimately increased levels of organic (capital) growth. In this case, an investor would be targeting a rise in the company’s share price as the prime investment objective, with income not being as important. Many smaller companies tend to be capital growth opportunities where cash preservation is often key, but there are also large cap companies such as Ashtead, the FTSE 100 equipment rental company whose share price performance over time has been hugely impressive. Some might say who actually needs dividends ?! It is typical to see high income tax paying investors targeting this group of companies as dividend income is low (upon which high levels of tax would become due).
A ‘value’ share is one which is arguably mispriced normally as sentiment toward it (or its sector) is negative. Some may called this group ‘the unloved’ and it tends to be the hunting ground of the contrarian investor : someone who likes to invest against the herd in search of returns. The contrarian approach, whilst a risky one can produce significant upside with patience; as an out of favour stock comes back into favour. Antony Bolton of Fidelity Special Situations fund fame (now retired) was a legendary contrarian value investor. A thorough understanding of a company’s financial statements would be an integral part of making this investment strategy work. A share may be overly depressed in view of its underlying financial health and a value investor would look to take advantage in such a case. With hindsight, when Rio Tinto was trading on a 5 year low at 1500p 15 months ago, a value investor may have taken a position, albeit it in a higher risk situation and made significant returns as the company recovered. The current share price is nearer 3000p so double.
Investors both new and existing need to know and fully understand the risk of investing in shares. When BP’s price halved in 2010 further to the Gulf oil spill, we were all given a crude (no pun intended) reminder of this; one of the largest companies in the world. The share price is still 25% below the pre-spill level. An investor new to shares needs to know that the bank account is safe (apart from inflation risk) and that shares, even if they pay a 5% income yield can go down as well as up. Careful research and stockpicking is needed to isolate opportunities with manageable levels of risk.
A lower volatility method to gain equity exposure might be through a managed fund (say an Investment Trust) which will hold many different company shares. This spreads company specific risk and certain funds may even hold different asset classes within them : shares and bonds for example which would reduce risk further. Ultimately each investor needs to understand what their objectives and attitude to risk really are with guidance from the adviser; in my case, the stockbroker.
Over the long term, it is well documented that equities have significantly outperformed alternative asset classes which vindicates the “buy and hold” strategy. Shorter term strategies aim to take advantage of market volatility. Shares bring inflation protection unlike the lower risk alternatives and this is very important. In addition, there are also tax advantages to holding some types of share (AIM listed for instance), where Inheritance tax will not be payable at the time of death.
This report was written by Philip Scott, Director at SI Capital Stockbrokers on 8/5/17 when the FTSE 100 was trading at 7300.