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Important notice to all investors:
While every care has been taken in the preparation of this document, AMP Capital
Investors Limited (ABN 59 001 777 591, AFSL 232497) makes no representation
2014
or warranty
as to the accuracy or completeness of any statement in it including,
AMP Capital
Investors
Limited Past performance is not a reliable indicator of
without
limitation,
any forecasts.
ABNperformance.
59 001 777 591
future
This document has been prepared for the purpose of providing
AFSL 232497
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
Understanding Equities
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 email [email protected]
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 invest5
>> How do equities fit into my portfolio5
>> Equity strategies5-6
>> Market indices 7
>> The performance of equities and the psychology of investing
7-8
>> Measuring performance9
>> Risks of investing in equities10
The importance of active management
10
2
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 shares1, either directly or through managed funds.
1. Australian Share Exchange, Australian Share Ownership Study, November 2012
3
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.
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.
A good source of income
Preference
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.
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.
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.
Comparison of ordinary and preference shares
Ordinary shares
Preference shares
Have a right to vote
Do not have any voting rights
Have the right to maintain No rights over the stake in
a certain percentage in
the company
the company
Do not know the dividend
amount you will receive
in advance
Dividends are fixed (although
in some periods there may be
reduced or no dividends)
Dividends can increase as
the company grows
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
Risk and return
characteristics
Exchange traded funds
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
Private equity
and hedge funds
Return
Equities
Bonds
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.
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.
When considering investing in shares, ask yourself:
Cash
>> What is my time frame for investment?
Risk
>> What sort of return do I want to achieve?
>> What level of risk am I prepared to take?
Source: AMP Capital. For illustrative purposes only.
>> Will I actively trade shares or take a long-term buy-andhold approach?
Investing in equities
>> Do I want income from dividends or capital growth in the
value of my shares?
Ways to invest
Equity strategies
Investing directly
Value and growth
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.
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
Value strategies
Growth 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’
Focus on companies
that show potential of
above-average growth,
even if the share price
appears expensive
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.
Greater focus on the value of the Aim to maximise their
share than the growth potential capital gains, even if this
of the company
comes at the expense of
receiving less income in the
form of dividends
Manager tends not to follow the
crowd or chase after popular
shares that may be overpriced
5
Long-short
Sector rotation
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.
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.
‘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.
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.
XYZ Stock
$3,000,000
$3,000,000
Borrows 1 million
XYZ shares from
broker
Returns 1 million
XYZ shares to
broker
SELLS
XYZ shares
@$2.00 per share
$2,500,000
$2,000,000
PROFIT
$500,000
$2m
$1,500,000
$1.5m
$1,000,000
BUYS
XYZ shares
@$1.50 per share
$500,000
$0
Day 1
Day 2
Day 10
Day 20
Day 30
For illustrative purposes only
6
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
Description
S&P / ASX 200
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.
S&P 500
Includes 500 of the most widely traded shares in the US. It covers about 70% of the market’s total value.
The Dow Jones
Industrial Average
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.
The Nasdaq composite
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
Subprime concerns
8000
7000
Lehman collapse
6000
5000
US Fed questions
sustainability of growth
Sharemarket crash
Asian crisis
Oil hits
$70
4000
Gulf War I
3000
2000
9/11 terrorist attacks
1000
0
1987
European debt
concerns
Gulf War II
Global bond
markets collapse
1989
1991
1993
1995
1997
Global financial
crisis
Russian crisis
1999
2001
2003
2005
2007
2009
2011
Source: History and the Australian share market, Global Financial Data, AMP Capital, January 1900 – July 2013. Past performance is not a reliable indicator of
future performance.
7
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
Fear
Optimism
Maximum
Financial
Risk
Maximum
Financial
Opportunity
Desperation
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
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
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
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.
Dividend yield
Annual dividend per share divided
by the price of the share
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.
Return on equity (ROE)
Net income divided by the
book value
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
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 59 001 777 591, AFSL 232497) 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
Risks of investing in equities