Investing Basics: What are Equities?

Investors in equities – interchangeably, ‘stocks’, ‘shares’ or ‘securities’ – essentially buy a fraction of the company they have chosen – writes Christian Leeming

 
Companies come in all shapes and sizes but all will have shareholders; whereas Dwain and José Pipe may jointly own the eponymous Dwain Pipe and Son Plumbing Services Co, public companies will issue millions of shares that are bought and sold on the stock exchange every day.

The value of a company is calculated by multiplying the number of shares it has issued by the value of each share.

A large number of individual shareholders may own small stakes in a company, whereas large asset management companies, pension funds or insurance companies (institutional investors) may own a significant portion of a listed company.

Public Limited Companies (PLCs) are limited liability vehicles which means that an individual cannot be held liable for losses that arise in excess of their investment; therefore, the potential downside of choosing to invest in a company that fails is the loss of your entire stake.

‘Investors in equities – interchangeably, ‘stocks’, ‘shares’ or ‘securities’ – essentially buy a fraction of the company they have chosen.’

The larger the number of shares that are issued, the lower the price per share and generally the higher the number of individual shareholders, the more liquid a stock tends to be; greater liquidity means that shares are readily traded with tighter bid/offer spreads.

Regardless of how small their stake, shareholders in a business may qualify for preferential terms on the company’s products or services and may have the opportunity to vote on matters of strategy and directors’ emolument at Annual General Meetings (AGM).

Once you have selected a company to invest in, your reward or otherwise will be directly linked to the financial performance of that business; you may receive dividends when the company performs well, or be asked for more money if it needs to pay off debts, wishes to pursue an acquisition or fund investment.

In order to grow its business a company may offer a ‘rights issue’ – the creation of additional shares, often with preferential terms for existing shareholders; existing shareholders have the ‘right’ rather than the ‘obligation’ to subscribe to a rights issue, but if they choose not to, the value of their existing holding will be diluted.

The price of a share may not directly reflect the financial performance of the issuing company; rather it is a reflection of market sentiment around that particular stock – a classic example of supply and demand.

If a company performs well and pays a dividend that may well attract buyers, which could in turn increase the market price of its stock; it is a quirk that in such circumstances the dividend as a percentage of its share price could then decline, thereby making the stock less attractive to investors seeking income.

Companies that are listed on an exchange for the first time undertake an Initial Public Offering (IPO) – ‘Tell Sid’ – and when an investor subscribes to participate, that is the only time that they will actually be buying shares from the issuing company.

Thereafter, any transactions are made in the ‘secondary market’ where shares are bought from, and sold to, other investors on an exchange, usually through a stockbroker.

Market makers will look at the level of demand for a particular stock and will decide on the price at which they will offer it for sale (offer) and how much they will pay for it (bid); the difference between the two prices is called the ‘spread’ and this is the profit margin on the transaction.

The ‘liquidity’ of a particular stock is a measure of the level of demand to buy and sell it during trading hours; bigger companies tend to be more liquid with a large number of transactions a day, which also tends to result in a narrow spread.

‘The ‘liquidity’ of a particular stock is a measure of the level of demand to buy and sell it during trading hours’

At the other end of the spectrum it may be difficult for shareholders in smaller companies to sell their holding, the most extreme example being that of a sole trader who can only sell their business when a purchaser comes along.

The internet has brought online trading and live prices to all, with transaction costs low and an efficient market ensuring fair pricing for buyers and sellers alike.

It also comes with masses of market data, information about a particular company and historical performance data to allow a would-be investor to make a informed choices.

It is generally believed that over the long term, and that may be the very long term, investing in equities delivers a better return than any other asset class.

‘£1 put into the British stock market in 1900 – and with dividends re-invested year in, year out – would now be worth £22,432’

£1 put into the British stock market in 1900 – and with dividends re-invested year in, year out – would now be worth £22,432; however, prices have increased 77-fold in the interim, meaning that in real terms, that investment is worth a more realistic £291.

That is a figure that eclipses the returns from investing in bonds, although the vast majority of the gain on equities comes from reinvesting dividends.

If investors spent the dividends as they came in, the £1 stake from 1900 would now be worth just £1.80p after adjusting for inflation; in the past two decades, bonds rather than equities have looked relatively attractive and in the noughties bonds showed a real return of 2.4%, whereas the return on equities did no more than keep pace with inflation – zero.