OCTOBER 2015
INVESTOR GUIDE
EQUITIES
COLUMBIATHREADNEEDLE.COM
PLEASE READ THIS IMPORTANT INFORMATION.
This brochure is a guide and does not cover all the factors that go into making
an investment decision. We have included within the guide some examples of
the tools an investment manager may use when picking stocks. It does not
aim to cover all of the tools that will be used to make the decision to purchase
a stock. Columbia Threadneedle Investments is unable to provide financial
advice and nothing in this guide should be interpreted as advice. If you are
unsure about anything you should speak to a financial adviser. For details
of one in your area please go to www.unbiased.co.uk - please note that we
do not endorse this website or the advisers found on it.
The material in this brochure is for information purposes only and is not
intended as an offer or solicitation with respect to the purchase or sale
of any security.
To help your understanding of specific terms used in this guide we have
included a glossary on page 11.
CONTENTS
01
02
03
04
05
06
07
08
Introduction. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2
Types of return. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3
What does the company do? . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4
Finances. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 6
What could go wrong? . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 8
What is it worth? . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 9
Summary. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 10
Glossary. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 11
Investor Guide to Equities
01
INTRODUCTION
Equities, also known as shares, give investors a stake in a company. If the company does well
the value of the shares may rise and you may be able to sell them at a profit. However, they may
also fall, making them a high-risk asset. Shareholders are also entitled to share in any profits
made by a company, which are usually distributed in the form of a dividend payment. In this
guide we look at what active managers look for when selecting stocks for their portfolios.
Companies are an important part of modern society.
Many of us work for one; almost all of us use them
in some way for the products and services that we
consume in our daily lives. Millions of people also
own shares in companies as investments – either
in their pensions or in other vehicles such as life
policies and ISAs. For centuries, entrepreneurs have
been setting up companies as a way of bringing their
ideas to the market. In the process of developing
these ideas, companies often require financial help.
At the same time, in other parts of the economy
there are entities – such as local authorities, pension
funds and private investors – with capital that they
wish to put to work.
The fund management industry helps to connect
companies in need of capital to investors who can
supply it. Fund managers allocate capital in ways that
are designed to earn a healthy return for their clients,
and buying shares in companies is one method of
doing this. In return for an initial injection of capital
2
to help companies undertake activities such as
building factories, buying supplies or hiring staff,
investors take part ownership of the company.
This entitles them to a share of future profits as
well as any increase in the value of the company.
So what makes a good company? The answer
depends on your perspective. What looks like
a good company from a consumer’s point of view
might not be so attractive from an investor’s stand
point. It is also important to distinguish between
a good company and a good investment, as they
are not always the same. A Rolls-Royce may be
an excellent car but if it is for sale for £2m, it is
not a good investment. Conversely, at £2,000
it may be a fantastic investment. So, as well as
identifying the characteristics that make a company
“good” – such as strong management, solid finances
and desirable products – we also have to decide
whether it will be a good investment by valuing it.
Investor Guide to Equities
02
TYPES OF RETURN
In looking at companies as potential investments,
fund managers try to ascertain what kind of returns
they might generate. These returns can come from
two main sources:
1. Capital growth
All companies’ share prices fluctuate and an investor
can make money by gaining from increases in a
company’s share price. Companies normally have a
limited number of shares and, if lots of people want
to own those shares, the laws of demand and supply
suggest that the share price will rise. Conversely,
poor quality companies that nobody wants to own
are likely to see their share prices fall. Fund
managers want to own companies whose shares
are likely to rise faster than the overall stock market.
2. Dividends
For many investors, generating income is an
important goal. Some companies pay part of
their profits out to investors in the form of regular
dividends, and fund managers will be looking to
calculate the value of these future payments
when assessing companies for a portfolio.
At the same time, investors’ needs vary depending
on their lifestyle and risk appetite. Many younger
investors are more interested in generating capital
growth, while more mature investors may prefer
to take an income from their funds. To meet these
needs, investment companies typically offer a
range of funds, and populate those funds with
the appropriate mix of either growth or income
stocks or both.
PORTFOLIO CONSTRUCTION
In addition to the kind of returns that a company
is likely to offer, fund managers will also consider
other factors such as volatility and liquidity.
For most portfolios, it is prudent to limit overall
volatility by spreading investments across the
market or by combining companies that are likely
to react differently to changes in the market.
It is also sensible to ensure that the bulk of the
portfolio is invested in highly liquid stocks that
can be sold quickly and cheaply if required.
The ability to balance these considerations
is a key part of a fund manager’s skill.
The balance between growth and income
stocks will depend on the objectives of the
fund. For example, smaller companies typically
pay out lower dividends or no dividends at all.
This is because they are often at an earlier stage
of development and will wish to invest all of their
profits in new equipment, staff or research.
Conversely, more mature companies or businesses
operating in industries with highly predictable
revenues may well pay out higher dividends.
3
Investor Guide to Equities
03
WHAT DOES THE COMPANY DO?
Different companies perform well in different
conditions, and the kind of business that a
company is engaged in is absolutely key to its
share price performance. When a company is
listed on a stock exchange it is classified into one
of a number of industries or sectors. These include
areas such as mining, retailing and utilities. The
fortunes of the companies in each of these sectors
are driven by different factors.
For example, a mining company may do very well
when the price of the commodity that it is mining
goes up, as this is likely to feed through to higher
sales and bigger profits. Meanwhile, a retailer will
prosper when consumer sentiment is positive,
unemployment and interest rates are low and
people feel like spending money. For a utility
company, demand tends to be more stable –
people drink water throughout the economic
cycle. So-called “non-cyclical” areas like this might
be more appealing when economic growth is weaker
and “cyclical” areas that are exposed to the economy
appear less attractive.
So, the kind of business is an important
consideration and fund managers will alter the
mix of industries in a portfolio to suit the prevailing
economic and market conditions.
PRODUCT DEVELOPMENT
Most companies will wish to build a range of wellestablished products that they can sell to a variety
of customers. However, businesses cannot afford
to stand still. In most industries competition is fierce
and, in order to be a leading player, it is necessary
to invest time and effort in developing new products.
A good example here is the pharmaceutical sector.
This is a relatively non-cyclical industry, as illness
unfortunately occurs irrespective of economic
conditions. However, better and more effective
drugs command a significant price premium and
new drugs are usually protected by a strict patent
framework that is enforced globally.
4
Thus, companies with the vision and expertise
to develop ground-breaking new treatments can
generate high levels of profit from them. For this
reason, pharmaceutical companies spend a lot
of time updating investors on products under
development. Conversely, companies whose
patents are approaching expiry, and which have
not invested in developing new drugs to drive future
profits, are likely to be shunned by investors because
they have limited future growth potential.
The aim of good product development in any sector
is to combine established products with more novel
introductions in order to ensure that consumer needs
continue to be met. This should allow the company
to generate healthy revenues. Thus, product
development is one of the key considerations
for an investor.
PROFITS VS REVENUES
Building a strong set of products and keeping it
up to date is vital if a company is to generate sales.
However, revenues are no good if it costs the
company more to make and market a product than
it can sell it for. The profit margin is the difference
between the cost of bringing a product to market
and the price received for it. Margins can vary widely
between companies and products and can be
a crucial driver of investment decisions.
Companies seek to grow their profit margins by
controlling costs and increasing revenues. Costs
come in many forms, including raw materials, labour,
transport and storage as well as sales commission
and advertising and promotional spend.
Investor Guide to Equities
Striking the right balance between revenues and costs can dramatically affect profits.
For example, consider three rival companies making mobile phones:
Company A
Company B
Company C
Retail price of phone
£100
£110
£120
Cost of production
£50
£57
£75
Sales commission
£15
£20
£25
Advertising costs
£9
£5
£18
Transport costs
£2
£3
£3
Margin
£24
£25
-£1
This is an illustrative example.
Although Company C makes the most desirable
product and is able to sell it for a higher price,
it has much higher costs and is actually making
a loss on each unit sold. This is not a sustainable
recipe for long-term success and would prompt
some serious questions from investors.
THE IMPORTANCE OF END MARKETS
Managers will also seek to understand where a
company’s profits are coming from. Many companies
operate internationally and factors such as economic
growth and the regulatory framework in various
markets can affect the money to be made from
international operations. In addition, currency effects
can have a significant impact on costs and profits
from overseas. Thus, understanding the geographical
breakdown of a company’s business is a crucial part
of the investment decision, as it provides insights
into how regional developments are likely to feed
through to profits.
MEET THE MANAGEMENT
Deciding how much to spend on product
development; which markets to sell into;
where to source materials, etc can significantly
affect the success of a business and its appeal
as an investment. These decisions are made by
the company’s senior management and, for this
reason, it is important for fund managers to meet
a company’s management team regularly in order
to interrogate them on their progress and plans.
Indeed, an experienced fund manager will have
a good knowledge of the best company executives
and, as people move around industries, it is
sometimes possible to spot opportunities
where a new team can invigorate a previously
unprofitable business.
5
Investor Guide to Equities
04
FINANCES
Understanding the products, end markets and quality
of management are key steps to making an informed
investment decision, but the company finances are
of equal importance. Shareholders are relatively low
in the pecking order if a company runs into financial
difficulty, so it is vital to understand what kind of
financial footing a company stands on in order to
be able to ascertain its long-term prospects. Fund
managers analyse the three key financial statements
to gauge a company’s finances:
1. PROFIT AND LOSS ACCOUNT
The profit and loss account (commonly shortened to
“P&L”) is an accounting statement that reflects any
sales made and costs incurred by a company over
a set period of time. In other words, it will show how
the company is converting its previous investments
in stock, equipment and other forms of capital into
wealth. It also indicates how the ability to generate
wealth is changing over time.
These are crucial considerations for shareholders as,
in return for the capital they have injected into the
business, they wish to receive a share of any wealth
created in the form of share price appreciation and
dividends.
6
2. CASH FLOW STATEMENT
No company can survive without cash – indeed, cash
is often described as the lifeblood of companies.
Like the P&L, the cash flow statement describes a
period of time, but the crucial difference is that it
shows the actual movements of cash into and out of
the business.
For example, a company might sell a product before
its financial year-end but not actually receive payment
until the following period. The sale would be reflected
in the P&L account for year one but would not appear
in the cash flow statement until year two.
Different businesses have very different cash flow
characteristics. Supermarkets have excellent cash
flow, as there is typically no lag between selling
goods and receiving payment. On the other hand,
companies involved in infrastructure projects such
as building hospitals for the government may have a
very different experience. They may sign a lucrative
contract in one year but not receive full payment until
well into the future. In the meantime, they will still
need cash to fund their ongoing operations.
No matter how good a company’s products are,
running out of cash can be a terminal problem.
As such, ensuring good cash flow is arguably the
number one priority of company management and
the cash flow statement is the key tool used by
potential investors to assess corporate health and
the long-term viability of businesses.
Investor Guide to Equities
3. BALANCE SHEET
Unlike the P&L and the cash flow statement, the
balance sheet gives a snapshot of a company’s
finances at a specific date. It contains details of
all the company’s assets, capital and liabilities.
Assets are the things that are of value to a
company, including its premises, equipment, cash,
investments, stock and patents. Capital is the money
put into the business by its owners. Liabilities are the
claims made by other entities against the business,
including debts and unpaid bills.
As its name suggests, investors use the balance
sheet to assess the balance between what a
company owns and what it owes. In tough economic
times fund managers will tend to favour companies
with high levels of cash on their balance sheets,
as this cash provides a buffer against lower sales
or higher costs of servicing debt. Having cash on
the balance sheet also allows companies to take
advantage of opportunities to expand by taking over
their rivals without having to raise additional capital.
In times of economic expansion, companies may
be encouraged to have less cash and more debt,
as there may be greater opportunities to expand into
new areas and the cost of debt is likely to be lower.
Managing the level of debt on the balance sheet is
a key ingredient of maximising shareholder value.
The three key accounting statements may look rather
dry to the layman, but each one provides a different
and complementary view of a company’s financial
position. As a result, each is used extensively by
fund managers in assessing the prospects and
financial strength of businesses.
7
Investor Guide to Equities
05
WHAT COULD GO WRONG?
The statements that we have just outlined help to quantify the financial risks and opportunities
that companies face. However, there are other risks that could affect the value of companies.
We highlight two other key risks here by way of example:
nnReputational risk – BP’s problems in the Gulf of
Mexico in 2010 provide an excellent example of
how a company’s reputation can be affected by
its operations. Most businesses involve some
form of risk and the oil industry is certainly no
exception. Companies like BP invest immense
amounts of money in order to extract oil from
increasingly hostile locations while minimising
environmental risk. Note the word “minimising”,
for the risk of machinery malfunctioning can
never be completely removed. BP’s share price
fell savagely after the disaster – indeed, it fell
by far more than most estimates of the likely
financial cost to the company. The difference is
the cost to BP’s reputation, as measured by its
potentially reduced ability to do business in the
US in the future.
8
nnRegulatory risk – most industries are subject
to some form of regulation and changes in
the rules governing businesses can significantly
impact investors’ assessments of the returns
that they can expect to receive. For example,
the recent financial crisis has led to expectations
of much tighter regulation of the financial
services industry. Investors have concluded
that this will limit financial companies’ ability
to generate profits. Analysing the likelihood of
tighter regulation and attempting to put a price
on companies’ ability to make money in the
future is a conundrum that is taxing fund
managers across the world.
Investor Guide to Equities
06
WHAT IS IT WORTH?
We have looked at the different kinds of companies,
how they make their money and the risks that they
face. Pulling all of this together, fund managers need
to make rational decisions about what different
companies are worth. To do this, they use a variety of
measures.
On a very basic level, the share price should give
some indication. However, shares are issued at
different prices, in different currencies and at
different times, so making direct comparisons
between companies on this basis alone is of little
use. Fund managers get round this by looking at
ratios of the share price to other financial metrics.
Among the most popular are:
nnPrice to earnings (“PE”) ratio. This divides a
company’s share price by the earnings that the
company is likely to generate per share. For
example, if a company’s share price is £100,
it is expected to generate total earnings of
£1,000,000 and it has 100,000 shares, the
earnings per share is £1,000,000 ÷ 100,000 =
£10 per share. And therefore, the PE ratio is £100
÷ £10 = 10. The company is said to be on a PE
ratio of 10 times earnings. Because share prices
are a means of valuing future cash flows, higher
earnings per share should lead to a higher share
price. Thus, dividing one by the other should allow
a more valid comparison of value between two
similar companies, with a lower ratio implying
better value.
nnDividend yield. Companies that pay dividends can
be compared using this measure, which is a ratio
of the dividends paid to the share price. Thus, if
the share price is £100 and the company pays a
dividend of £5 per annum, the dividend yield is £5
÷ £100 = 5%. If the share price stays stable and
the company continues to pay the same dividend,
this is the return you can expect to receive. If the
share price goes up but the dividend stays the
same, the dividend yield will fall. Income-seeking
investors favour this measure as a way
of comparing the appeal of different companies.
nnThese measures – and others – are all useful
for assessing value in different sectors and at
different stages of the economic cycle. Like the
financial statements outlined on pages 6 and
7, they represent different perspectives on a
company’s value.
nnA fund manager’s skill lies in reconciling a
company’s valuation with its future prospects.
All participants in the market are constantly
assessing these prospects, so the valuation
is ultimately a function of the consensus view
of the future. When a fund manager takes a
different view of the future, he will conclude that
the company valuation is either too high or too
low. Either of these scenarios represents an
investment opportunity.
nnPrice to book value (“P/BV”) ratio. This is a
similar concept to the PE but, rather than using
earnings per share, it uses the value of all the
company’s assets minus its liabilities. Therefore,
the P/BV ratio is more focused on what the
company actually owns rather than an estimate
of what it will earn in the future. Many “value
investors” prefer to use this measure as they
believe that it gives a truer and less volatile
indication of what a company is worth.
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Investor Guide to Equities
07
SUMMARY
In selecting stocks for a portfolio, fund managers
seek to gain an in-depth understanding of how a
company operates, how profitable it is and how
strong its finances are. They then assess these
fundamental factors in light of the company’s
valuation relative to other investments, both in terms
of the scope for share price gains and the likelihood
of dividend growth.
At Columbia Threadneedle Investments our
highly regarded team works together, debating
and challenging consensus views to ensure that
our best investment ideas are leveraged across
portfolios. This approach has delivered excellent
long-term performance, and we are confident that
our clients will continue to benefit from this expertise
in the future.
The diverse nature of stock markets means that
there are many different kinds of opportunities,
from small companies to large and from cyclical
businesses to those whose profits are not
dependent on the economic outlook. By the
same token, markets are always changing and
this presents risks as well as new openings for
companies to exploit.
As always with any type of investment, please be
aware that past performance is not a guide to future
returns and that you may not get back your original
investment. Columbia Threadneedle Investments
is unable to provide investment advice so if you are
unsure whether an investment is suitable for you,
you should contact a financial adviser. For details
on one in your area visit www.unbiased.co.uk
- please note that we do not endorse this website
or the advisers found on it.
Talented fund managers are able to consider all of
these moving parts and use their experience and
judgement to make high conviction calls on which
investments offer the best potential for their clients.
10
Investor Guide to Equities
08
GLOSSARY
Balance sheet – accounting statement detailing a
company’s assets and liabilities at a given point in
time
Bottom line – another term for profit or loss (derived
from the fact that this figure is shown on the bottom
line of a company’s P&L account)
Capital – the total assets of a person or organisation
minus their total liabilities
Capital growth – an investment return generated by
changes in the price of a share
Cash flow statement – financial statement showing
all the inflows and outflows of cash over a given
period
Non-cyclical – company whose profits are relatively
independent of the economic cycle
P&L – financial statement detailing the wealth
created by a company’s activities over a given period
PE ratio – valuation measure defined as a company’s
share price divided by its earnings per share
Price to book value – valuation measure defined as
a company’s share price divided by the value of all its
assets
Profit – the excess of cash generated by a business
over the cash used during the period
Revenue – proceeds of a company’s sales
Cyclical – company whose profits are relatively
dependent on the pace of economic growth
Sector – way of grouping companies according to the
industry that they operate in
Dividend – the regular payment of part of a
company’s profits to its shareholders
Top line – another term for a company’s revenues,
or sales
Dividend yield – valuation measure defined as the
dividend divided by the share price
Valuation – way of assessing the cheapness of
company shares. Examples include price to earnings
ratio and dividend yield
Liquidity – the ease or difficulty with which an
investment can be bought or sold
Volatility – the extent to which the value of an
investment fluctuates over time
Margin – the difference between the cost of
producing something and the revenue gained from
selling it
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Investor Guide to Equities
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or call 0800 953 0134*
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Important information. The value of investments and any income is not guaranteed and can go down as well as up and may be affected by exchange rate fluctuations. This means that an investor may not get back the amount invested.
The research and analysis included in this document has been produced by Columbia Threadneedle Investments for its own investment management activities, may have been acted upon prior to publication and is made available
here incidentally. The mention of any specific shares or bonds should not be taken as a recommendation to deal. Any opinions expressed are made as at the date of publication but are subject to change without notice. Information
obtained from external sources is believed to be reliable but its accuracy or completeness cannot be guaranteed. Threadneedle Asset Management Limited. Registered in England and Wales, No. 573204. Registered Office: Cannon
Place, 78 Cannon Street, London, EC4N 6AG. Authorised and regulated in the UK by the Financial Conduct Authority. Columbia Threadneedle Investments is the global brand name of the Columbia and Threadneedle group of companies.
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Issued 10.15 | Valid to 04.16 | J24335